Have you ever heard the word ‘bond’ used in finance before and wondered what it is? Maybe you’ve looked it up, only to be met with a definition you couldn’t understand?
Finance and economics have their own language to define certain concepts or ideas, their own jargon. This jargon is confusing and long-winded, when really all you want is a simple answer.
To make it easier, here’s an explanation of what a bond is and how it works, in plain English.
What is a bond?
A bond is not a physical thing, it’s a type of loan.
When you buy a bond, you are lending money to the company, organisation or government who issues the bond (bond issuer).
When you lend the bond issuer the money, this is known as buying a bond. The bond issuer agrees to pay you extra (interest) in return for lending them the money.
The bond issuer pays you this interest at certain times throughout the length of the loan, known in finance as a loan term. Then, at the end of the loan term, they repay the original amount, known as the principal.
Bonds work as ‘investment tools’, because essentially you are investing your money for a certain period of time and making money off the process.
How does a bond work?
Not all bonds are the same, they range from very safe to very risky, and the money you earn on the investment depends on how safe the bond is.
In general, bonds are less risky to invest in than shares. However, there is always a risk that the borrower will not be able to repay the loan. This is why a riskier investment will earn you more money, you will get a higher interest rate and your interest payments will be higher.
The majority of bonds have a credit rating, just like you have a credit rating, to show how likely you are to pay back a loan. However, the agencies that decide what bonds are rated only make this information available to wholesale clients and advisers. Wholesale clients typically invest $500,000 or more, or have net assets worth over $2.5million. So it can be difficult for retail investors, individual investors or small businesses, to determine the level of risk.
This is why many see bonds as a ‘rich person’s game.’
How does a bond issuer value a bond?
Bond values are not set in stone, and can change depending on the current interest rate, the amount of interest the bond issuer has made since the last interest payment, and if the interest rate on the bond changes.
For example, if a bond is valued at $100, and you bought it nine months after the last annual interest payment was made, you would need to pay the bond issuer more than $100. This is because you need to take into account the interest that has already been added on to the value of that bond in those nine months.
If the rate on the bond changes during your loan term, the bond value can either increase or decrease. Let’s say for instance, you buy a bond for $100, at an interest rate of 4%. In one week, the interest rate increases to 8%. The interest rate has doubled, so the interest you are paid from the bond would increase by half, however the price of the bond would decrease in value.
Similarly, if you bought a bond last week at 6% interest, and the interest rate halved to 3%, the interest you earn on the bond would decrease by half, yet that would increase the overall price of the bond.
Why do bond values go up when interest rates go down?
It seems a bit backwards, and trust me when I first read this I was very confused, but a simple way to look at it is, that interest rates and bond values move in the opposite direction to one another.
The price of the bond increases as the interest rate lowers in order to make sure that newer bonds are not more attractive to buy than ‘older’ ones.
This, in turn, stops investors from buying older bonds, with shorter loan terms.
Why would you buy a bond?
Many investors choose to ‘buy’ bonds (loan money to corporations and governments) as they provide ‘predictable’ income. If investors do not sell the bonds during the agreed loan term, they will get back the entire amount they invested at the beginning, on top of their interest payments.
Another reason why you might buy bonds as an investor, is to sell them and make a profit. To do this, you would need to sell the bond at a higher price than what you paid for it initially.
For instance, if you bought $10,000 worth of bonds, and their market value increased to $13,000 (this would also mean the interest payments decreased) you could sell them and pocket the $3,000 difference.
How would you sell a bond as a retail investor?
If your bonds are listed on the Australian Stock Exchange (ASX) and you want to sell them before they reach their ‘maturity date’ (the end of the agreed loan term) it’s important to assess their current market price (so you do not lose money) and find a buyer.
Assessing their current market price is different to assessing stocks, as bond prices change based on supply and demand. Lower priced bonds are usually more attractive to buyers, as they have a higher interest rate, and therefore the buyer will receive more money in interest than a higher priced bond.
However, if market interest rates drop dramatically since the time you bought your bond, you could end up making a profit from your sale.
Let’s say the market interest rate was 4% when you bought your bond paying 6% with a loan term of ten years. Five years later, the market interest rate is only 2%, and the ‘spread’ has increased from 2% (4-6%) to 4% (2-6%). This means the bond is now more attractive to investors as it is paying higher interest than new bonds, priced on the new 2% market interest rate.
This all seems complicated but in fact it is only a very simple look at bonds and how they are valued. Many other factors come into play in the bond market but I hope this gives you a little more insight.
Now next time one of your friends or family talks about the bond market, you should be able to hold a conversation with them about it. You may even be able to learn more from them about the complexities of bonds, as you will know the basic premise, and therefore, the right questions to ask.