What are bonds and how do they work?

Bonds: the word is familiar, and many people have them – even if they don’t realise it. But what exactly are they? What makes their price move, and what are the risks and rewards?   

Bonds are the opposite end of how we usually experience loans, because we are usually the borrower. Using a mortgage to buy a house is a good example of this. 

In fact, the easiest way to think of bonds is as interest-only mortgages, but with you acting as the bank or building society. You lend money to a company or government, they pay you an agreed rate of interest and, at the end of the loan period, the loan is paid back in full.      

When bonds are first issued, the loan amount is set in fixed units, called the ‘nominal value’. This is the face value of the bond and the amount you will get back if you still own it when the time comes for it to be repaid. Sterling bonds are usually issued with a nominal value of £100. 

The interest rate – or ‘coupon’ – is set at the outset and depends upon:

  •  The prevailing rates of interest over the period – called the ‘duration’ – of the bond, and 
  • How reliable a borrower that company or government is likely to be. 

Getting to grips with the jargon

Like equities, bonds are known by several different names such as ‘fixed interest securities’, ‘fixed income’, ‘corporate bonds’, ‘gilts’, ‘bunds’ and ‘treasuries’. 
At their heart, bonds are really quite simple. They are a loan from an investor – for example, loaning part of your pension fund – to a company (a corporate bond) or a government (a government bond).

Some key terms:

  • Fixed interest securities – implies that a fixed rate of interest is paid.
  • Fixed income – a regular amount of income is paid.
  • Gilts, bunds and treasuries – these are simply names for specific government bonds; in this case, UK government bonds, German government bonds and US government bonds respectively.  

Companies and governments that are high-risk borrowers, meaning they could default on interest payments or the whole loan, pay higher rates of interest. For example, the Greek government has to pay an interest rate of about 7% to borrow money over 10 years, whereas the UK government pays an interest rate of only 1.3% over the same period. This is because the Greek government is perceived by lenders – buyers of its bonds – to be a poorer credit risk than the UK.  Other investors and fund managers buy and sell bonds once issued.  These buyers pay a market price for the bond depending upon the coupon – the interest rate, remember – relative to current interest rates over the remaining duration of the bond. Other factors such as the strength of a company or the economy, and inflation, also influence the market price. 

Remember that, in the event of a default, you may not get back what you invest.

What makes the price go up or down?

Let’s assume you bought a 20-year UK government bond or ‘gilt’ with a nominal value of £100 and a coupon of 5% (you get £5 a year interest) in 2007. There is now only 10 years left of the original 20-year term.

 Once issued, a range of factors can influence the price of a bond, including:

  • Changes in market interest rates. The prevailing interest rate to lend to the UK government over 20 years back in 2007 may have been around 5%, but today, the market rate of interest for government bonds over the remaining term of the gilt – 10 years – is only 1.3%.  The bond still pays a 5% coupon but that 5% is clearly more attractive than the 1.3% available today, therefore investors are willing to buy that gilt at more than its face value of £100. Buying a bond for more than its face value is referred to as ‘buying above par’.  Of course, the opposite can happen and interest rates might rise after the bond is issued. In this case, the coupon that it pays looks unattractive relative to current interest rates and the price of the bond falls. Buying a bond below face value is called ‘buying below par’.
  • Inflation. The current value of future interest payments and the final repayment of the nominal value will depend upon future inflation. If inflation is expected to be high over the remaining period of the bond, the value of the bond will be lower than if inflation was expected to remain low.  
  •  The company’s or government’s prospects. If a company is in difficulty, with high debts and low profits, it is perceived as carrying a higher risk of defaulting on its bonds and must pay a higher rate of interest to borrow money. As we often hear on the news, the same goes for a government – budget deficits and the total borrowings relative to economic production (for example, gross domestic product or GDP) might affect a government’s credit rating.     

The price and the yield

One of the most difficult concepts to grasp is the relationship between the price of the bond and the yield...  

When the price of a bond rises, the yield falls.
When the price of a bond falls, the yield rises.

The yield, which is not the same as the coupon, is the market rate of return and is usually measured in one of two main ways:

 

 The ‘running’ or ‘daily’ yield

Let’s return to our example of a 20-year UK government bond, or gilt, issued in 2007 with a coupon of 5%. At outset, the running yield would have been 5% – in other words, a £5 coupon was payable, based on a nominal purchase price of £100. 

 Interest rates have fallen over the last 10 years and the outlook is for continued lower interest rates. That means a 5% coupon is an attractive rate of interest and buyers will pay more than the £100 nominal value of the bond. Let’s say the current market value of this gilt is above par at £130 and, of course, it still pays a £5 coupon. 

 This means the current running yield is £5 divided by £130 or 3.8%.

If the price of the bond had fallen, then the running yield would have increased. For example, if the current price of the bond was below par at £80, the running yield would be £5 divided by £80 or 6.25%.

The running yield only tells us what the current rate of interest is relative to the price paid. It doesn’t really tell the full story, because it doesn’t include the nominal value we will get back when the bond matures.

For example, if someone paid £130 for a bond with a face value of £100, they will make a loss of £30 if the hold the bond until it is repaid. The running yield doesn’t take this potential loss (or gain if we bought the bond below par) into account. To do this, we need to look at another way to define the yield...

The ‘redemption’ yield

This is also called the ‘yield if held to redemption’ or the ‘yield to maturity’.    
The redemption yield takes into account the gain or loss we might make on the face value when it is repaid at the end of the term. Again, using our example, if we pay £130 for a bond with a face value of £100, we will make a £30 loss.
We know that the remaining term is 10 years, so we could say roughly that we will lose £3 a year (that is our £30 loss divided over 10 years) on the purchase price. But we also make a gain of £5 a year from the coupon, so our net gain is £2 a year. This simplistic calculation is called the ‘simple yield’.
However, the £30 loss will not crystallise for another 10 years. A more accurate calculation would be to work out the compound annual rate of interest that would result in a loss of £30 in 10 years time. 
This is what the redemption yield calculation does. Fortunately, there’s no need to worry about the maths, as the redemption yield of government bonds is available online and in real time.
However, what you should remember is that the redemption yield is probably the best measure of the value for money – the interest rate – that you’re getting when you invest in a bond.

You might also be interested in…

Bonds: balancing risk with reward

Bonds: when you should and shouldn’t consider them

 

AR01916  02/2017

 

 

Back to top