Bond definition

What is a bond?

A bond is a financial instrument or debt security that represents a loan made by an investor to a borrower. The borrower can be a company or a government. They’re seen as a ‘safer’ investment compared to stocks, because a company’s or government’s failure to repay a bond means that something is wrong in the underlying financial system itself, and it rarely happens.

Bonds are a form of ‘fixed-income security’. In this context, ‘security’ just means ‘investment’. Bonds are known as fixed-income securities because they pay an annual, predetermined interest payment to the lender.

 

How do bonds work? 

To fully understand how bonds work, we’re going to break down the key terminology that you’ll hear when you’re looking to invest in bonds. Let’s get into it.

Issuer: this is the company or government that issued the bond. The issuer is also known as the ‘borrower’, because this is the entity that is looking to borrow money from a ‘lender’. The ‘lender’ is the investor or financial institution that buys the bond. The issuer is obligated to repay the face value of the bond at maturity and make periodic interest payments.

Maturity date: this is the date that the bond matures (or, ‘expires’), and the issuer is required to repay the face value to the lender. Bond maturities can range from a few months to several decades.

Face value: this refers to how much a bond will be worth on its maturity date. It’s the same as the initial price of the bond, and it’s the amount that the lender will receive when the bond matures, on top of the bond’s interest payments. For example, a bond could have a face value of £1,000.

Coupon rate: the coupon rate is the interest rate that the issuer agrees to pay to lenders. It is usually expressed as a percentage of the bond’s face value and determines the periodic interest payments. For example, a bond with a 5% coupon rate and a face value of £1,000 will pay £50 in interest to the lender each year.

Market price: bonds can be bought and sold in secondary markets, and their prices can fluctuate based on changes in interest rates. The market price may be higher or lower than the bond’s face value, affecting the bond’s yield to maturity. For context, bonds and interest rates have an ‘inverse relationship’ – when interest rates go up, bond prices fall; when interest rates go down, bond prices rise.

Yield to maturity: ‘yield to maturity’ is the total return an investor can expect to receive if they hold the bond until its maturity date. It takes into account the bond’s current market price, the coupon rate, and the time left until maturity.

Bonds serve various purposes for both investors and issuers. Investors can buy bonds for income and diversification, while issuers use bonds to raise capital for various purposes, including to fund projects, refinancing debt, or managing liquidity.

Bond markets are an essential component of the global financial system, and there are a wide variety of bonds out there for investors with different risk profiles and investment goals. With Moneybox, you can invest in funds that track the price of corporate bonds and government bonds.

 

All investing should be long term (min. 5 years). The value of your investments can go up and down, and you may get back less than you invest.