Client Qs: How do bonds work?

 By Mike Ross

What is a bond?

When you invest in a bond, you are essentially lending money to a company or government entity. In return, they promise to pay you back the original amount you invested (known as the principal) after a certain period of time, along with regular interest payments.

How do you get paid?

The interest rate on a bond, also known as the coupon rate, is determined when the bond is issued. It's usually a fixed percentage of the bond's face value. For example, if you invest $1,000 in a bond with a 5% coupon rate, you'll receive $50 in interest payments per year.

Why does the value change? 

The value of a bond can change over time, and one of the key factors influencing this change is interest rates. When interest rates in the market go up, it means that new bonds being issued are offering higher coupon rates. This makes them more attractive to investors because they provide a higher return. As a result, existing bonds with lower coupon rates become less desirable.

If you own a bond with a 5% coupon rate and interest rates in the market rise to 6%, new bonds will offer higher returns than yours. Investors will want those higher returns, so they won't be willing to pay as much for your bond with the lower coupon rate. As a result, the value of your bond will decrease because its fixed interest payments are now less competitive compared to newer bonds.

Conversely, if interest rates fall, new bonds will offer lower coupon rates. This makes your existing bond's higher coupon rate more attractive, as it provides a higher return than the newly issued bonds. Investors may be willing to pay a premium for your bond, driving up its value.

To summarise, when interest rates rise, bond values tend to go down. When interest rates fall, bond values tend to go up. This happens because changes in interest rates affect the relative attractiveness of different bonds in the market.

Individual bonds vs bond funds

It's important to note that changes in bond value due to interest rate fluctuations primarily affect bonds traded on the secondary market. If you hold a bond until maturity, you'll receive the full principal amount as promised, regardless of interest rate changes. However, if you decide to sell your bond before it matures, the current interest rate environment will impact its market value.

Bond funds invest in a range of bonds. The advantage of investing in bond funds is that they provide diversification, spreading the investment across a range of different bonds issued by various entities, such as governments and companies. This diversification helps reduce risk compared to investing in just one or a few individual bonds. Additionally, bond funds allow investors to access a wide range of bonds with varying maturities and credit qualities without the need for a large initial investment.