In this post, you will learn the key terminology surrounding bonds and how bonds can be bought and sold on the secondary market.
Contents
What is a bond?
A bond is pretty much an ‘IOU’. Person A issues the bond to Person B in exchange for a loan. The bond itself contains details of how Person A will repay the loan to person B, how long they will take to repay it and the amount of interest that will accrue on the loan amount.
A bond will also specify when the end date of the bond is. This is know as the ‘maturity date’ and it is the date upon which Person A agrees to pay back the entire amount of the loan (the ‘principal’) to Person B.
In reality, Person A is usually a government, official body or a company. If the bond is issued by a company, it is known as a ‘corporate bond’. Bonds issues by governments or official bodies are usually called ‘government bonds’, ‘government securities’ or ‘gilts’ within the UK.
Why do governments and companies issue bonds?
The main reason why governments and companies issue bonds is to raise money. For example, a government may need funds to construct a new railway line or to build more schools. Rather than relying on the money it receives from taxes, a government could issue bonds to raise the required cash instead.
Similarly, a company may wish to expand its business by buying new assets or recruiting additional staff. Rather than using the profits from the business or relying on the sale of new shares, it could issue bonds to raise the required money to fund these projects instead.
For the issuer, a bond is a type of ‘debt’. This is because the issuer (e.g. a company) is borrowing money from the person who purchases the bond (the ‘bond holder’). The issuer will eventually have to pay the principal back to the bond holder, together with any interest, once the bond reaches maturity. The individual is incentivised to buy the bond in the first place because the issuer promises to pay them interest (also known as the ‘coupon’) on the money that they have loaned to the issuer.
Are bonds risky?
Being a bond holder comes with a certain amount of risk. In effect, you are lending money to a government or organisation in return for a promise that they will pay you back with interest. Sometimes, that government or organisation will fail to honour their promise and will be unable to repay the money that you have lent to them. This is called ‘defaulting’ on the debt.
Because the issuer may default on the debt, as a bond holder you want to ensure that you are lending your money to a reputable and trustworthy issuer who can fulfil their promise to repay you your money.
Imagine that Company A is a business with strong profits, low levels of debt and a good credit history. Compare this with Company B, which is struggling to break even, has already defaulted on a few of its debts and is struggling to fulfil its customers’ orders. If both companies issued bonds that paid the same amount of interest over the same time period, you would much rather lend your hard-earned cash to Company A because the available evidence indicates that you have a higher chance of being paid back.
Luckily for us, there are certain organisations whose job it is to rate the riskiness of bonds. The most well-known of these organisations are Standard & Poors, Moody’s and Fitch Ratings. Each of these ‘credit agencies’ rank the riskiness of bonds from prime (i.e. the least risk) to default (i.e. the most risky).
Generally speaking, the rule with bonds is that more risk equals more reward. Buying a ‘prime’ bond will increase the chances that you will be repaid, but the amount of interest you will earn will be lower as a result. Conversely, buying a lower rated bond will usually pay you a higher rate of interest, but the chances that the issuer will default on the debt are higher.
Where can you buy bonds?
Bonds can be purchased in a number of ways. One method would be buying the bond directly from the issuer. This would involve waiting for the issuer to issue a new bond and then purchasing that bond directly from the organisation.
Alternatively, bonds can be bought on the ‘secondary market’. The secondary market allows existing bond holders to sell their bonds to other people. This means that you do not have to wait for an organisation to issue a new bond before you can buy one of their bonds. If that organisation has issued a bond in previous years, you can buy that bond from someone else who already owns it.
To give you an example of how the secondary markets work, imagine Company A issues a £100 bond that matures in 10 years and pays a fixed coupon of 1% per year. Person A buys the bond and holds it for 5 years, earning £5 of interest in that period.
Person A then decides to sell the bond to Person B on the secondary market. Person B purchases the bond from Person A for £100 and holds it for another 5 years until maturity. Person B earns £5 of interest (1% per year on £100 for 5 years) during that period and Company A pays Person B the initial £100 (i.e. the principal) on maturity.
You can also gain exposure to the bond markets by investing an in index fund. If you’re not sure what an index fund is, read this post to find out more.
Can the price of a bond change?
Bonds which are sold on the secondary market will fluctuate in price. In the example we used above, Person B bought the bond from Person A for £100, which was the same amount that Person A paid for it in the first place.
In reality, the price of that bond on the secondary market is likely to change according to the prevailing interest rate on other debt at that time.
Using our previous example, imagine that 5 years on from issuing the bond, Company A issues another £100 bond that matures in 10 years. But this time, instead of paying a 1% coupon per year, the new bond now pays a 2% coupon per year. If Person A tries to sell his old bond to Person B for £100, suddenly this is not such a good deal for Person B. Instead, Person B could use his £100 to buy the new bond and earn a higher rate of interest (2%).
As such, the value at which Person A can sell his bond to Person B on the secondary market will decrease. This is because Person A’s old bond (which pays 1%) is now less valuable than the company’s new bond (which pays 2%). Bond holders want to maximise their return and the 2% interest on the new bond is much better than the previous 1% on offer for the old bond.
Therefore, the new value at which Person A will be able to sell his bond on the secondary market is £95 (the old bond is trading at a ‘discount’). If Person B bought the old bond from Person A at this price, his return after 5 years would be the same as if he spent £100 on the new bond which pays 2% interest (i.e. an overall return of £10). This is because the old bond would earn Person B a coupon of 1% on £100 for 5 years, which equals £5, plus an additional £5 which will be paid to Person B by the company on maturity (the £100 principal minus the £95 which Person B paid Person A for the bond).
This example demonstrates that if the price of the bond on the secondary market fluctuates, this does not change the amount that the issuer has to pay back to the bond holder on maturity. The issuer will always pay back the initial price of the bond on maturity (known as the ‘nominal value’), regardless of the bond’s price on the secondary market.
In addition, the coupon that the issuer must pay to the bond holder throughout the life of the bond is based upon the bond’s nominal value, not its value on the secondary market.
What does ‘bond yield’ mean?
A bond’s yield is the real rate of return that a new purchaser of a bond can expect to receive when buying a bond on the secondary market.
Because the price of a bond on the secondary market can go higher or lower, this will change the real rate of return that a new purchaser of the bond will receive.
For example, if a bond is selling for higher than its nominal value (known as trading at a ‘premium’), a new purchaser of the bond will have to pay more money to own the bond. However, the initial interest rate on the bond (the ‘coupon’) will remain the same.
To demonstrate this, imagine that a £100 bond pays a 1% coupon per year. If that bond is now selling on the secondary market for £120, a new purchaser of that bond has to pay £120 to receive the same 1% coupon (remember, the coupon is paid on the nominal value of the bond, not the price of the bond on the secondary market).
However, the new purchaser has had to pay £20 more than the nominal value of the bond. Therefore, his effective rate of return is actually lower than the 1% coupon he will receive, because he has had to pay an additional £20 to own the bond in the first place.
When the price of a bond on the secondary market increases, as in our example, the yield of the bond goes down. Conversely, when the price of the bond falls, the yield of the bond goes up. Therefore, the price and yield of a bond are inversely related.
Conclusion
Bonds play an important role in the portfolios of many investors, and understanding how they work is an essential step in any investor’s journey.
Do you have any questions about bonds? Leave me a comment below and I’ll get back to you with my answers!