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What are bonds and how do they work?
Published on 30/06/2023
Topics:
investments
By Tom Miller
Bonds are, in simple terms, loans made by investors to "bond issuers" - which are usually governments, councils (local government) or companies. When investors buy bonds, they are essentially lending money to the bond issuer for a specified period of time in exchange for regular payments (coupons), and the eventual return of the investment which is specified at the time of issue - the 'maturity' date. The upfront investment is called the 'face value' and is the amount of money returned at the end of the investment - as long as the company or government doesn't fail. The coupon payments are based on interest rate that is set at the time of the bond being issued.
Levels of risk with bonds
Lending to a government - either central or local council - is generally less risky than lending to a company. However, this means government bonds usually have lower returns than corporate bonds because they are lower risk. Corporate bonds usually have higher returns than government bonds because investors require additional compensation for the increased risk. The financial health of a government is usually backed by a population that pays taxes which provides confidence to investors of a government's ability to repay a bond investment. Global credit rating agencies such as Moody's, Fitch and S&P assess the relative ability of different bond issuers to repay their investors.
Bond values
If an investor holds a bond until maturity, the value that they get back is the maturity value (usually the same as the face value). The value an investor receives might be different to the maturity value if the investor sells the bond before maturity. This is because the value of a bond can go up or down depending on a variety of factors, including changes in interest rates, the financial health of the bond issuer, and overall market conditions.
When interest rates rise, the values of existing bonds generally fall. This is because investors can now earn a higher rate of return on newly issued bonds. This decreases the demand for older bonds with lower interest rates, which causes their value to decrease. Conversely, when interest rates fall, the values of existing bonds generally rise. This is because investors are willing to pay more for the fixed coupon payments that these bonds offer, since it's harder to find comparable investments that can provide the same level of return.
The financial health of the bond issuer can also affect the value of a bond. For example, if the issuer's credit rating drops, investors may become concerned about the issuer's ability to repay the loan. Investors usually will demand a higher return for this increased risk, causing the bond's value to fall.
Overall market conditions can also affect bond values, including changes in investor sentiment and economic instability. During times of uncertainty, for instance, investors may seek out the relative safety of bonds, causing their values to rise. Conversely, during times of economic growth and optimism, investors may be more willing to take on riskier investments, causing bond values to fall.
How bonds are bought and sold
Individual bonds can be traded on bond markets, usually either through a sharebroker (including banks) or through different online services. Many managed fund providers like Simplicity also offer bond funds, which pool investors' money and spread these investments across a number of different bond types and issuers. This provides diversification across bond maturities, interest rates or 'coupon' and yields (the total expected return). Bonds are also commonly part of the asset allocation (i.e. the investment mix) within a KiwiSaver fund, usually in higher proportions for those fund types with a lower risk profile.
