Investing in bonds
Think of a bond as a loan you can invest in. Learn how bonds work, how you earn interest, and how their risk compares to stocks.
The word "bond" might sound technical, but in simple terms, it’s a form of debt. Here's how it works.
What is a bond?
A bond is a loan you can invest in. They're issued by companies and governments that need to raise money. When you buy a bond, you're essentially lending money to the issuer. In return, you earn interest. But like stocks, bonds can also be bought and sold on financial markets, and if the price is right, you can sell at a profit.
The interest paid on a bond is often called a coupon or coupon rate.
Bonds have a fixed term
Like any loan, a bond has an agreed term, for example, ten years. This means the borrower (a company or government) must repay the loan in full by the end of that period. The amount they repay is called the face value, and it's typically €1,000. Depending on the type of bond, repayment happens in one lump sum at the end of the term or gradually over the life of the bond.
What is face value?
The original value of a stock or bond, as set when it's issued.
The risks of bonds
If you buy a bond and hold it for its full term, you'll receive your money back by the end, either in one lump sum or in installments during the term. However, if the company or government goes bankrupt, you may not receive your full repayment.
The risk of a borrower defaulting is something to keep in mind when investing in bonds. It's also possible that a borrower temporarily runs into difficulty and can't make interest payments. Despite these risks, bonds are generally considered safer investments than stocks, because in the event of bankruptcy, lenders are prioritised above shareholders.
The price of bonds
What makes bonds different from ordinary loans is that they can be bought and sold on financial markets. Like stocks, they have a market price that fluctuates constantly.
The price of a bond is influenced by supply and demand, but also by other factors, among which:
📈 | ⏳ | 🛡️ |
|---|---|---|
Capital market interest rates | Remaining term | Creditworthiness of the borrower |
Capital market interest rates
Bonds are traded on the capital market: the financial market where investments with long terms (generally at least two years) are bought and sold.
This rate is usually equivalent to the rate on government bonds, which are bonds issued by national governments.
But capital market rates change over time, and those changes affect the price of bonds that were issued earlier:
👩🏻💼 | 📉 | ⬇️ | ⏳ |
|---|---|---|---|
Sophie buys a bond paying 3% interest. A few years later, the capital market rate rises to 4%. | Sophie's bond suddenly looks less attractive to other buyers, because newly issued bonds are now offering better returns. | For Sophie, this means she would make a loss if she sold now. | What she can do, is hold on to the bond until the end of its term, when she will be repaid its face value. |
Remaining term
The closer a bond gets to the end of its term, the more its market price moves toward face value — the amount originally borrowed. This makes sense: as the repayment date approaches, it becomes increasingly certain that you'll get your money back.
Creditworthiness of the borrower
A bond's price also reflects how confident the market is that the borrower can repay. For some borrowers, that's a safe bet. For others, it's far less certain.
Take an Argentine government bond. Argentina has defaulted on its debt multiple times and remains economically unstable. The risk of non-repayment is considered high. Consequently, the interest rate Argentina has to pay to borrow money is relatively high: as compensation for the higher risk faced by investors.
The Dutch government, by contrast, has an excellent track record on debt repayment. As a result, the interest rate the Netherlands has to pay to borrow money is lower, because investors face less risk of not getting their money back.
Creditworthiness can change over time, of course. If a borrower’s creditworthiness declines (and the risk of them being unable to repay increases), investors demand a higher interest rate. This causes the price of existing bonds, which still pay the old, lower interest rate, to fall. Conversely, the price of existing bonds rises if the borrower’s creditworthiness improves (the risk then decreases and the interest rate on new bonds falls).
Key takeaways
- Bonds are loans issued by companies and governments that need to raise money.
- Investing in a bond earns you interest over the life of the loan.
- At the end of the bond's term, the borrower must repay the full amount borrowed.
- Bonds can be bought and sold on the capital market before the term ends.
- A bond's price is determined by supply and demand, capital market interest rates, the remaining term, and the creditworthiness of the borrower.