What is... | March 4, 2014

What is a bond?

Three of the best-known, basic ways for people to invest are shares, bonds and cash deposits. It’s not unusual for commentary on share market price movements or the rate of interest earned on cash to fill column inches in newspapers and, depending on the company, conversations over dinner.


However, bonds don’t seem to attract the same level of discussion – despite being regarded as a handy halfway house to diversify between the risk of shares and property and the safety of cash.

How do bonds work?
As ING senior economist Ian Bright explains in the video How bonds work, a bond is a loan. Or, more technically, it is a large loan that has been split into packages and sold to investors.
Bond holders typically make money by receiving regular payments of interest (known as coupons) during the life of the loan. The life of the loan might be as short as one or two years or as long as 30 years or more.
The idea is that when the loan ends, their original investment is returned.
However, as with any investment, there is a financial risk that investors will lose money.
The term halfway house is used for bonds as they are considered safer than shares but they are more risky than a bank deposit.

I’ll take a bundle of company bonds please
Investors can buy individual bonds or opt for units in a bond fund. Like shares, bonds or bond funds can usually be sold at any time – meaning they tend to be highly liquid.
The two main types of bonds are corporate (loans made by companies) and government (loans made by government).
Of the two, corporate bonds are seen as more risky because the likelihood of a company issuing the bond going bankrupt is generally higher than a government doing so.

Bonds and the financial crisis
Our four tips for bond buyers explains that when interest rates rise, bond prices typically fall.
Given that interest rates were at record lows in many countries during the global financial crisis that started in 2007, this relationship is of particular note as interest rates have – or are likely to – rise back to “normal” levels as the recovery takes hold.
However, there is evidence that many people are not aware of the dynamic, with a 2009 US survey finding only 21% of respondents knew the relationship between bond prices and interest rates.
Different types of bonds are, though, designed to work in different financial conditions. In particular, bonds that are “index-linked” to the Consumer Prices Index (CPI) are designed to protect against inflation, which can eat away at the spending power of money over time. This can be attractive to investors who want to ensure the value of their investment does not fall if prices rise.

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eZonomics team
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