An Introduction to Bonds

An Introduction to Bonds

Introduction to Bonds from MOXI Wealth

Bonds are simply a loan packaged into a neat financial product. You lend money to a company or government and as a ‘thank you’ they pay you interest. 

How do they work?

When a company needs a big loan that is too large for a bank or individual investor to take on they break it down into smaller, equal portions and ask many investors to lend to them at the same time. These portions are called bonds. The bonds come with interest payments aka ‘coupons’ and an expiry date.

Each bond costs the same, for example, if a company need a £1,000,000 loan they could issue 10,000 bonds at price £100. If you buy one of these bonds you are in fact lending £100 to the company in return for interest payments. When bonds expire the loan is paid back in full. This happens by the company buying back all the bonds it initially issued.

Buying bonds at issue

Investors who buy bonds when they are newly issued are the first buyers – they are buying direct. If they hold onto the bonds, they receive regular interest payments until expiry where they receive the full amount back. This concept is similar to putting your money into a fixed-term saving account.

What’s the risk?

Unlike saving in UK bank accounts, your money is not covered by the financials services compensation scheme. If the company behind the bond go bust, you may not get your money back. On the upside, there are plenty of robust companies selling bonds and if you decide to take a risk on a less robust company, you will be rewarded with much higher interest payments. You can read more about the risks here.

Buying in the ‘secondary’ market

The first buyers can sell the bonds before they expire. The selling and buying of bonds after issue is called the secondary market. As these trades happen the price of the bond changes. In the secondary market, the price is no longer fixed at the issue price (e.g. £100) it could be at a higher (premium) or lower (discounted) price.

What happens at expiry?

The company or government that originally issued the bonds will buy them back at the issue price. That is, if you buy a bond at a discount you will make money from the price difference at expiry. For example, you buy a bond for £90 and at expiry, you get £100. But, if you buy a bond at a premium you will lose money on price at expiry. For example, you buy at £110 and at expiry you get £100. This may leave you wondering, ‘why would you ever buy bonds at a premium?!’. You can read more on that matter here.

Bond investment strategies

You could buy and hold bonds as a ‘safer’ investment paying regular interest. Or, you can buy a much riskier bond for a (potentially) high return. You can also use bonds to trade expected interest rates changes – When a central bank’s interest rate falls, the price of bonds go up because their interest payments become more attractive. You can read more on investment strategies here.

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