What is a Bond?

Simply put, bonds are investments representing debt of a government, company, and other organisations. Bonds are issued by organisations holding the debt and then purchased by banks, companies, and private investors.

 How do bonds work?

The entity which is borrowing the money is known as the issuer. The buyer acts as the lender. The issuer issues a number of securities* and commits to paying a generally fixed rate of interest paid annually or semi-annually, which is called a coupon. The date set for the repayment of the money is known as the maturity or redemption date.

After the primary market, wherein bonds are sold to investors via banks or private brokers, bonds can be traded between different investors and market counterparties. Bonds are usually traded on an institution-to-institution basis, such as from a bank to a broker.

Types of bonds

Corporate bonds can be issued by companies instead of seeking bank loans for debt financing, as the bond markets can offer lower interest rates, and more favourable borrowing terms.

Government bonds in the UK are also known as gilts and are issued by HM Treasury and listed on the London Stock Exchange. The term gilt derives from their secure nature. Different types of gilts include conventional gilts, which is a liability of the government agreeing to pay the holder a coupon biannually. Another type of gilt is index-linked gilts, which differ from conventional gilts as their coupon repayments are adjusted to the UK Retail Price Index (RPI), with a slight time lag.

Savings bonds are fixed-term cash savings accounts offered by banks, building societies, institutions backed by the state and the likes instead of traded market securities. They tend to be targeted at medium to long term investors.

Bonds and interest rates

A bonds interest payment is fixed once issued, yet market interest rates fluctuate. The price of the bond is what adjusts to keep them competitive with whatever newer bonds are currently offering. If interest rates rise, newly issued bonds will pay more and reduce the attraction of lower-coupon bonds. This makes the bonds’ price fall so its effective yield* rises to match the market. If interest rates fall, newly issued bonds pay less, and the existing higher-coupon bonds appear more attractive. This makes the bonds’ price rise as buyers are willing to pay a premium for larger rewards.

The effects of interest rates on bonds are especially relevant at the moment with the Bank of England chief warning of interest rate rises.

How popular are bonds?

Over 22 million people in the UK hold premium bonds, and there is over £136 billion invested. Premium bonds are issued by the National Savings and Investments (NS&I), and work by a £1 stake being entered into a monthly prize draw. HSBC data suggests that roughly 18% of investing adults own individual bonds. Millions in the UK also own bonds without realising it, as around 48% of gilts, the UK’s national debt, is held by domestic institutions. This means that anyone with a workplace/personal pension fund or a multi-asset investment fund effectively owns a share of government and corporate debt.

What will bonds look like moving forward?

Higher yields from bonds increase the price of borrowing, putting governments in a delicate situation. For investors, government bonds are still vital in managing risk. The US has seen its 30-year bond yields reach 5.63%, which is its highest level since 2002. These high yields will provide a robust income cushion against volatile markets, benefiting pension funds and savers who can now earn more from safe assets, while making mortgages, business loans and government debt more expensive, which is likely to slow the housing market, squeeze smaller companies and limit what Washington can spend.

Green bonds provide a look into the future for a sustainable investment route. They enable investment into projects that help the environment, encourage climate investment, and generate growth in domestic debt capital markets. Other forms of bonds that promote sustainable, responsible investing, whilst generating returns for investors, will be interesting to watch in the coming years.

*Securities – Investments, such as shares and bonds, that can be bought and sold and give the holder either part ownership of an organisation or the right to be repaid money it has borrowed.

*Yield – The return you would earn if you bought a bond at current market price and held it until maturity.