What are Bonds?

Governments and companies frequently need to raise finances in order to finance new investments and projects. Rather than taking a loan, they can issue bonds.

A bond is a debt investment where an investor loans money to a company or Government for a defined period of time for at an agreed interest rate.

They are different from shares because they pay interest and do not provide a stake in the issuing organisation.

How Bonds work

Investors lending to governments or companies can buy the bond and in return every year the bond will pay interest. This is often referred to as the coupon.

Bonds have a maturity date – this is the date when the government has to pay back the principal, the original amount it borrowed. Government bonds are issued with a range of maturity dates, from short term bonds to those which have a 30-year lifespan.

Bonds are debt securities which can be traded amongst investors. The market price of the bond will depend on a number of factors including the credit rating of the issuer, the length of time until maturity and the coupon rate compared to current interest rates. When someone sells a bond at a price lower than the face value, it's said to be selling at a discount. If sold at a price higher than the face value, it's selling at a premium.

Bond trading example

A 10 year bond is issued with a 6% coupon value. If interest rates were to rise to 7%, the 6% coupon value is below the current market rate and not an attractive option for investors. The bond price will decrease and will sell at a discount.

If interest rates were to fall to 3%, the bond will continue to pay at 6% and will be an attractive option for investors. The price of the Bond will increase and be sold at a premium.

How are Bonds issued?

Bonds are usually issued in a bond auction. Most government bonds are bought at auctions by primary dealers such as large banks and financial institutions. Buyers of bonds include banks, pension funds, foreign governments and individual investors.

Where are Bonds traded?

Corporate and government bonds can be traded publically on exchanges. They are often traded over-the-counter (OTC) – this means they are generally traded between dealers, acting on behalf of clients.

Government Bonds explained

Governments and companies frequently need to borrow money from the markets and do this in a number of ways. Rather than taking a loan they issue bonds, debt securities that can also be traded between different parties. They are different from shares because they pay interest and do not provide a stake in the issuing organisation. They are really pieces of a structured loan.

How Bonds work

Bonds are debt securities – governments and companies use them to borrow money to fund projects or expansion plans. Anyone lending to governments or companies can buy the bond and in return every year the bond will pay interest. This is often referred to as the coupon.

Bonds also have a maturity date – this is the date when the government has to pay back the principal, the original amount it borrowed. Government bonds are issued with a range of maturity dates, from very short term bonds to those which have a 30-year lifespan.

In addition, companies and local governments (municipalities) issue bonds. There are thousands of individual bonds issued on the market at any one time.

How are Bonds issued?

Bonds are usually issued in a bond auction. Most government bonds are bought at auctions by primary dealers like large banks. Buyers of bonds include banks, pension funds, foreign governments and individual investors. 

Where are Bonds traded?

Bonds can be traded and the market for bonds is wide and diverse. Corporate and government debt is mainly traded in the over-the-counter (OTC) market – this means they are generally traded between dealers, acting on behalf of clients.

When someone sells a bond at a price lower than the face value, it's said to be selling at a discount. If sold at a price higher than the face value, it's selling at a premium.

Bond ratings

Independent ratings agencies exist to provide a rating to bond issues: a rating is an indicator of risk – how likely is it that a borrower will default and fail to pay the bond at maturity?

Only the most secure bonds attract the top ratings. Even large governments may only have AA or A ratings.

What is a junk Bond?

A junk bond is a much riskier, high yield bond, often issued to raise short term financing. These are not investment grade – i.e. the risk of default is considered much higher. 

What drives bond prices?

• Demand for bonds on the part of long term investors, particularly institutions
• The supply of bonds – how many new bonds are coming onto the market
• Bond ratings, particularly if these are upgraded or downgraded
• Interest rates being paid by banks
• The state of a country’s economy, including how much it is borrowing, and whether the market thinks it will be able to pay its debts
• Whether the equity market is seen as too risky – historically, the bond market was regarded as a safer place to invest. This has changed since countries like Greece are in danger of going bankrupt
• How long a bond has to go before it is redeemed (the principal is paid back). This will influence the price, as investors will know how much more they can expect in terms of interest payments

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