What is a bond?

Revolut · June 12, 2024Tiarnán McCartney

Bonds are an important asset class in the world of finance — offering investors both stability and reliable returns.

Bonds are issued by governments and corporations when they want to raise money. As an investor, you can effectively lend money to companies like Apple and Google, as well as governments like the EU, by investing in a bond. In return, the borrower (bond issuer) promises to pay back the initial investment (known as the principal), along with regular payments (known as coupon payments) made over a specified period (known as the maturity period).

Let's take a closer look at bonds to understand how they work and what the fuss is all about:

What are the different types of bonds?

There are various types of bonds, each with its own set of characteristics and risk profiles.

Some common types include:

  • Government bonds
  • Corporate bonds
  • Municipal bonds
  • Treasury bonds
  • High-yield bonds (some times referred as junk bonds)
  • Savings bonds

How do bonds work?

Put simply, bonds work similarly to loans. When a company or government is looking to raise a bit of capital, they might decide to issue bonds. Investors buy bonds, effectively lending money, and in return receive regular interest payments until the bond matures. Upon the bond's maturity, the investor gets back the money they initially invested.

When an investor goes to buy a bond, they'll be provided with its maturity date, coupon rate, and the frequency of payments.

The key characteristics of bonds

Bonds have several key characteristics that differentiate them from other types of investments:

  • Fixed income: bonds typically offer fixed interest payments at regular intervals
  • Maturity date: bonds have a specified maturity date, upon which the principal amount is repaid to the investor
  • Credit quality: bonds are rated based on how likely the issuer is to repay, affecting the risk and potential returns

How are bonds priced?

A bond's price can change due to various factors such as interest rate changes, developments in the financial situation of the issuer, and ‌market demand. Generally, when interest rates rise, bond prices tend to fall, and vice versa. Also, bonds from issuers with higher ratings scores usually cost more because they're perceived as a safer investment.

What do bond prices have to do with interest rates?

The relationship between bond prices and interest rates is usually inverse. This means when interest rates go up, the prices of existing bonds with lower coupon rates tend to drop. This is because newly issued bonds will offer higher interest rates, making them likely to be more attractive to investors. On the other hand, when interest rates decrease, bond prices usually go up with investors seeking out higher returns.

What is yield-to-maturity?

Yield-to-maturity (YTM) is an important number that tells investors how much they'll make if they hold a bond until it matures. It considers the bond's current price, how much interest it pays (the coupon rate), and how long is left until it matures. YTM helps investors compare different bonds, even if they have different interest rates and maturity dates.

The yield-to-maturity can vary: generally, as interest rates rise, the YTM tends to increase; as interest rates fall, the YTM usually decreases.

How to buy bonds

You can now buy bonds with ease on Revolut. Simply head to the app and go to Invest to explore our range of fixed-income investments.

Frequently Asked Questions

1. What is a bond rating?

A bond rating is an assessment of the creditworthiness of a bond issuer, conducted by credit rating agencies such as Moody's, Standard & Poor's (S&P), and Fitch. With S&P's and Fitch, the ratings range from AAA (highest quality) to D (default). Bonds with higher ratings usually pay less interest, but they're safer because the borrower is less likely to fail to pay back the loan.

2. Can I sell my bonds before the maturity date?

Yes, investors can sell their bonds before the maturity date in the secondary market. However, the sell price of the bond might be lower than the price at which you bought it. It all depends on what's happening in the market and if interest rates have changed. Some bonds have low liquidity and might be difficult to sell.

3. How does bond maturity affect price?

As bonds approach maturity, they usually get closer to their original value, assuming there's no risk of the borrower not paying back the principal. So, the closer they get to being paid back, the less effect changes in interest rates have on the bond’s price tag.

4. How does inflation impact bonds?

When prices for things we buy go up (that's inflation), it generally makes fixed-income investments like bonds less valuable. As inflation rises, the real (inflation-adjusted) return on bonds decreases, usually leading to a decline in bond prices and yields.

About the risks

Investing in bonds, while often considered safer than stocks, still carries its share of risks. These include interest rate fluctuations, credit risk, inflation eroding returns, liquidity issues, and reinvestment risk. It’s also important to remember that a company or government may default at any point during the bond duration, potentially resulting in the total loss of your initial investment. Managing these risks is essential for maintaining a balanced portfolio.

Investment services are provided by Revolut Securities Europe UAB (305799582) - an investment firm authorised and regulated by the Bank of Lithuania. Revolut Securities Europe UAB does not provide investment advice. Capital at risk. Returns are not guaranteed. You may receive less than your original investment or lose the entire value of the initial investment. Past performance and forecasts are not a reliable indicator of future results. Returns may be affected by currency fluctuations. Further information can be found on our Risk Disclosure and Trading FAQ. Revolut’s cryptocurrency and commodities services are offered by Revolut Ltd (No. 08804411).

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