What is a bond? Simply explained

If you've heard the term 'bond' being used in a financial context, you might have already guessed that it's an important term in investing. In this article we explain what a bond is and how bonds are generally used and viewed in the realm of investing.

A bond is simply a loan

A bond is essentially a loan to a company or government. In exchange for the money you lend, you receive a fixed interest payment every year.

At the end of the term, you get your full investment back, unless the company or government in question goes bankrupt, in which case you can kiss your money goodbye. It’s also possible that such an entity faces financial difficulties, temporarily preventing it from paying interest.

This might sound a bit daunting, yet bonds are generally considered relatively safe investments.

Investing in bonds through ETFs

If you invest in bonds through ETFs, like you do with Peaks, you’re investing in many different bonds at once. The value of these bonds can fluctuate over time.

That’s where things get a bit more complex. Supply and demand, the ECB’s policies, and interest rates significantly influence bond prices.

The value of a bond changes

A bond’s price isn’t fixed, just like with shares. However, it tends to fluctuate much less.

The volatility—also known as risk—of a well-diversified bond portfolio is historically about four times lower than that of a broadly diversified stock portfolio. This is why bonds are generally seen as less risky than stocks for the short term, but some experts challenge this perspective.

Still, bond prices do change, which means your returns can also fluctuate when investing in bonds.

If you hold a bond until maturity, you know you’ll get your initial investment back—the price at which you bought it. However, if you sell a bond before it matures, you’ll have to deal with the market price at that moment. That price could be higher or lower than when you first invested.

Choosing between bonds

Take a Greek government bond versus a German one, for example. These two countries have different credit ratings.

Creditworthiness refers to the likelihood that the issuers of bonds can pay interest every year and return the principal at the end of the term. In other words, the chance of getting back the money you lent.

A German bond has a different credit rating than a Greek bond. German bonds fluctuate less than Greek ones and are therefore less risky.

Credit rating labels

Credit ratings range from AAA, AA, A, and BBB—meaning these are relatively safe investments.

Anything above BBB is considered a high-risk bond, ranging from BB to D. D stands for Default, which means bankruptcy—definitely not a smart investment.

At Peaks, you can invest in bonds with ratings from AAA to BBB.