What is a bond? (2024)

In this session we are going to focus on the very basics of the elements that make up a bond security. We are also going to answer the most common questions investors have about bonds:

• What is a bond?
• What does a bond holder get?
• How do you buy and sell a bond?

What is a bond?

First of all, a bond is really just a loan. In any normal loan agreement, you have someone who is the lender, who lends the ‘principal’ or capital to a borrower, and is paid in return an amount of interest, and at the end of the period of the agreement, will also get the principal back, assuming the borrower does not default, and has not paid back the loan before the end of the term.

A bond really captures that flow, that idea of lending money and of the payment of the interest, and the final repayment of the principal, and packages that into a bond security. A bond, like an equity, is a financial asset that can change hands between financial market participants. Ultimately, a bond is a loan, packaged up into a piece of paper, or now into an electronic agreement, where there is a contract between the two parties.

What does a bond holder get?

A bond holder has the right to the return of the initial investment (the principal) at the end of the agreed loan period (the maturity date). A bond holder will also receive an amount of interest, known as the ‘coupon’ of the bond, and that coupon could be ‘fixed’, e.g. 3% per annum, or it could be ‘floating’ or variable, and linked to e.g. inflation, or it might be linked to cash rates, such as LIBOR (London Interbank Offered Rate) or SONIA (Sterling Overnight Index Average).

A bond holder also has the ability to enforce rules over a company, and we call these rules the ‘covenant’. For example, if an investor buys a bond from a riskier company, the terms in the bond covenant may stipulate a maximum amount of aggregate debt that the company is allowed to take on. Such a term may help to ensure that the bond holder stays at the same level of ‘seniority’ in the company’s capital structure, and what that means is that if the company goes into difficulties, the bond holders who are more senior will be among the first to receive assets of the company, if it does have to be wound up. Covenants can protect bond holders, to a certain extent, and can help to make sure that bond holders are in a safer position. Bond holders, unlike equity holders, have no votes, and no voice at the company’s Annul General Meeting (AGM), which is where shareholders are able to hold the company executive to account. Bond holders have no say. Covenants are therefore important in terms of protecting bond holders’ interests.

Bond holders, unlike equities, have no participation in the future growth of the company. If an investors buys the bonds of a large tech company such as Apple, in that situation, the investor would receive the fixed (or floating) coupon per annum and then the principal back at the end. But whether Apple performs extremely well or underperforms, this will not affect the outcome for a bond holder (unless Apple were to encounter such difficulties that the coupon and principal payments could not be met). If the Apple share price doubled, bond holders would not participate in this gain.

How do you buy and sell a bond?

Unlike a stock market, there are no bond ‘exchanges’. The bond market is what we call ‘over the counter’, so investors who want to buy and sell bonds go to a broker who acts as an intermediary between parties. In the bond market, the parties are usually institutional investors, such as fund management companies or sovereign wealth funds. Typically, bond trades tend to be of a larger size than equity trades; bonds often have a minimum investment level. Bonds are generally viewed as more complex investments than equities, so retail investors typically do not participate directly in these trades – there is a retail bond market, but it is very small compared to the institutional bond market.

So this is a slightly more difficult area of the market for investors to get involved in directly (as opposed to investing in funds that buy bonds), as buying and selling bonds is a slightly more arcane process than buying and selling equities.

Bond indices

Although bonds are not traded on an exchange, there are a number of companies that produce both price histories and active prices for bonds. So if you are looking at very liquid bonds such as those from large international companies or those issued by governments, and also for less liquid bonds, for example from smaller companies or which entail very high risk, you will be able to obtain a ‘buy’ and ‘sell’ price through data providers such as Bloomberg. Based upon these prices, you can produce indices, and these are largely geographic. Some of the major indices are produced by Bloomberg Barclays, BofA Merrill Lynch and iStoxx, and many of these will produce a global aggregate index, and then further ‘sub-indices’ based on geography, for example.

Another point that is important when looking at a bond is creditworthiness, and we’ll come onto this in a future video, but depending on what we call the ‘credit rating’, which is basically a score given by a rating agency to a bond in order to denote the latter’s creditworthiness. Depending on a bond’s credit rating, it will fall into a different ‘bucket’ when it comes to bond indices, which often differentiate by credit rating, either instead of or in addition to geography.

Finally, there are indices that are divided into specialist areas. I mentioned before that most bonds are typically a fixed amount of investment over a given period, so the bond holder receives a coupon plus return of the principal at the end of the term, but some of the coupons might be variable, for example linked to inflation or to another factor, and there are specific indices for these ‘index linked’ bonds and for floating rate bonds. Bonds can also be specialised in terms of the underlying securities from which they derive their cashflows, which means that there are indices that focus on, for example, asset-backed securities.

Important information

The value of your investments and the income from them may go down as well as up and neither is guaranteed. Investors could get back less than they invested. Past performance is not a reliable indicator of future results. Changes in exchange rates may have an adverse effect on the value of an investment. Changes in interest rates may also impact the value of fixed income investments. The value of your investment may be impacted if the issuers of underlying fixed income holdings default, or market perceptions of their credit risk change. There are additional risks associated with investments in emerging or developing markets. The information in this document does not constitute advice or a recommendation and investment decisions should not be made on the basis of it.