Understanding bonds

What are bonds?

A bond is effectively an ‘IOU’ issued by either a government or corporation. By investing in a bond, you are essentially lending money to one of these entities. In return for your investment, the issuer delivers an agreed level of income in the form of a fixed rate of interest (coupon). At an agreed date, the Government or Corporation will return the face valueFace valueThe value of a bond that appears on the face of the bond, unless the value is otherwise specified by the issuer. Face value is ordinarily the amount that the issuer promises to pay at maturity and is not an indication of current market value. (issue price) of the bond, known as the maturity value. The illustration below demonstrates the lifecycle of a bond as if held from the day of issue.

Investors can also invest using the fixed interest market, where bonds of all types can be bought and sold. In the fixed interestFixed interestReferring to income which remains constant and does not fluctuate, such as income derived from bonds, annuities etc. Any debt security which has a fixed flow of income is known as a fixed interest security. market, the price of a bond may actually be less than its original issue price or face valueFace valueThe value of a bond that appears on the face of the bond, unless the value is otherwise specified by the issuer. Face value is ordinarily the amount that the issuer promises to pay at maturity and is not an indication of current market value..

What are the different types of bond?

There are several types of bond, each offering different levels of return, with corresponding levels of risk:

Yield

The yieldYieldA measure of the income received from an investment compared to the price paid for the investment. Normally expressed as a percentage. is usually expressed as a percentage, obtained by dividing the current market priceMarket priceWith reference to a security, the last reported price at which the security sold. Alternatively, the highest price which a buyer, willing but not compelled to buy, would pay, and the lowest a seller, willing but not compelled to sell, would accept. of the bond into the annual interest payment. As a price of a bond declines its yield rises.

Let’s look at a 4% bond. If you were to buy it for £1,000, the current yield would simply be running at 4% (£40/£1,000). But if the price drops to £800, the yield rises to 5%.

Why? Because the guaranteed coupon - £40 – is now 5% of the £800 you paid for the bond (£40/£800). If the price rises to £1,200, the percentage shifts down to 3.33%.

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