Learn more about bonds

April 7, 2015 / Knowledge Centre

Bonds are an important part of the investment world for investors. Sometimes bonds are called ‘obligations’ or ‘fixed income’ and there are many different types of bonds available on the market today. 

In this article we will examine what a standard bond is, which parties are involved in the bond transaction, how bonds work and how bonds can offer protection and regular income to investors. 

A bond is a loan issued by a company, in which case it is called a corporate bond, or a governmental organization, which are called governmental bonds. The interest that is paid to the investor who buys the bond from the issuer is a fixed amount and is called the coupon. (Hence the alternative name ‘fixed interest’)

Each bond tends to have a fixed term at which the issuer will pay back the initial loan to the investor. In the meantime the issuer will compensate the investor by paying the coupon on a regular basis. Bonds therefore are suitable for investors who seek a predictable and regular income stream. 

Bonds differ from equity as bond holders have lent money to the bond issuer and therefore there is a liability towards to bond holder by the issuer. In case of financial difficulties liabilities need to be paid first before any left over money is paid back to equity shareholders. Bond holders therefore have more rights than shareholders and it is generally accepted that many bonds are less volatile and safer than equities. 

However, even between bond holders there is a picking order. The highest level are represented by senior bonds, then normal and the lowest category are subordinated bonds. Senior bond holders are always paid in full first, next the standard bond holders and finally the subordinated bond holders. Because of this the coupon paid to subordinated bond holders usually is higher in order to attract the investor and compensate for the higher credit risk.

Another word frequently used in connection with bonds is ‘yield’ this figure represents the effective income that an investor can expect to receive if he buys the bond and holds it to maturity. The yield can be higher or lower than the agreed ‘coupon’ due to the fact that the price of the bond itself fluctuates. Based on expectations related to the stability and credit risk of the issuer investors are prepared to pay either more or less than the nominal value of the bond. If the investor pays more than the nominal value his yield will be lower, but if he pays less than the nominal value his yield will be higher.

For example, if the bond that the investor wants to buy has a coupon of 5% and the current price equals 80 cents on the dollar his yield will be 6.25% instead of 5%. (You get 5% on 100, but only paid 80 cents for the bond 5/80 equals 6.25%) 

Buying good quality bonds during times of stress in the financial system can be a lucrative strategy.