What is a bond?
(3 min read)
What is a bond?
The term ‘bond’ is used across the Financial Services industry to describe many different types of financial products. Examples include ‘investment bond’, ‘fixed rate bond’, ‘offshore bond’, ‘corporate bond’, ‘government bond’ and others.
In this article we explore bonds in the context of Fixed Income - also referred to as Fixed Interest - which often forms part of a balanced investment portfolio alongside asset classes such as equities or property.
Instead of buying shares in a company (equity), you can lend your money to a company (corporate bond) or government (government bond) in return for interest payments and capital repayment at maturity of the bond’s term.
A good measure of the quality and reliability of a bond is given by its credit rating, which is issued by rating agencies such as Moody’s and Standard & Poors, in a similar way that individuals can get credit scores. Bonds with a poor credit rating tend to promise a higher coupon/yield to attract investors, whereas a bond with a strong credit rating to reflect its dependability might offer a lower coupon.
How do bonds work?
Bonds are loans or debt. A mortgage is a bond and in fact, in many parts of the world, people refer to their mortgage or other loans as bonds.
Bonds carry an interest rate known as a coupon that is either fixed or floating (like a mortgage) dependent on the prevailing official/Bank rate at the time of issue. A bond’s ‘yield’ is the rate of interest an investor can expect to receive. For example, UK government bonds (known as ‘Gilts’) that were issued when the bank base rate was at close to zero, carry coupons or annual interest rate as low as 0.125%, whereas gilts issued very recently carry a coupon closer to 5% reflecting the recent rise in bank rates.
Bonds can have short or long maturities out to typically 30 years, although 100-year bonds have been issued. A bond’s length to maturity is noted by the terms ‘short-dated’ or ‘long-dated’.
Bonds can be issued by any type of entity, governments, corporates and supranational organisations and the interest rate or bond yield will be determined by the creditworthiness of that entity. Companies generally pay a higher coupon than governments to reflect the relatively higher risk attached to the loan.
Bonds with longer maturities are more sensitive to the change in interest rates and this became very apparent in 2022 when yields sharply increased and longer dated bonds lost significant capital value. A key metric to note is that a bond’s yield typically moves inversely to its price, so if bond yields are rising then their corresponding price will fall. The yield will be higher when the bond price falls because the fixed interest receivable will be a higher proportion of the lower capital value.
The bond market is important because it reflects the monetary or interest rate policy of the day and the credibility of that policy. It is also important because it is a major factor in pricing other asset classes. For example, property or equities might be more attractive when interest rates or bond yields are low than when they are high. Investors might find high bond yields more attractive than owning other asset classes.
Montgomery Associates Investment Committee
October 2023
Find out about more financial terms on our glossary page: www.montgomeryassociates.co.uk/glossary
