What is a bond?
Bonds are popular sources of funding for companies and preferred investments for investors. But what is a bond? How can I purchase a bond? And does investing pay off? The most important facts about bonds explained.
Bond: Terms and interest
As the name itself indicates, a bond is an obligation. The issuer of the bond receives money from an investor on mutually agreed terms and undertakes to repay the capital at the end of the term and compensate the investor with interest.
Bonds are fixed-rate investments with a pre-defined term and interest rate. So that this rigid construct can adapt to changes in market conditions, the price changes – in the opposite direction of the interest rate. As interest goes up, prices go down, and vice versa.
The fluctuations in price increase as the term of the bond increases. The longer it is until a bond's repayment date, the more sensitive it is to changes in the interest rate environment. This sensitivity is known as the bond's duration.
Bond: Bond issuers
When it comes to issuers, there is generally a difference between governments and companies. (Western) governments usually ensure repayment. Whether or not a company can be trusted with repayment depends on the quality of its balance sheet and its performance. Independent agencies measure this trustworthiness and summarize it with a rating. This rating directly influences the amount of the bond's interest.
If the issuer reports a solid balance sheet and good performance, the investor can rest assured that the bond will be repaid, and will be content with a relatively low interest rate. If the balance sheet is weak or shows inconsistent revenues, investors need a higher interest rate so that their investments are seen as relatively attractive. If this situation changes, then the assessment often changes, too, and has a corresponding impact on the interest. This is how a company that is reducing debt can improve its rating. In contrast, the rating will be lowered if bankruptcy is looming for an issuer. In this context, one speaks of the creditworthiness of the issuer.
Bond: Risks and returns
Although bonds are very stable and predictable investments, they cover a broad spectrum of risk-return profiles. A portfolio of government bonds with high creditworthiness and a lower duration rarely experiences price fluctuations, but also has lower interest. If investors want higher interest, they also have to take on additional risks. They can make concessions at maturity whereby the interest rate is increased. Or for the issuer's creditworthiness, which in turn leads to higher vulnerability when it comes to economic performance. This might influence the likelihood of repayment.
A characteristic of all bond portfolios is that the specific risks are reduced through diversification, i.e. distribution among many different investments. For example, rising interest rates at the short end can be compensated by falling interest rates at the long end. If an issuer is downgraded or defaults, it carries less weight than if there are dozens or hundreds of other positions in the portfolio.
Bonds are usually traded on the stock exchange and kept in safekeeping accounts.
When trading, it should be noted that the liquidity of some bonds is very low, which results in large differences between buying and selling prices.