A bond is a loan to a company or government. It is often for a set term. At the end of this term you will get back your loan provided that the company or government is still in business.
In return for your loan, you are paid interest, sometimes called “coupons”. The coupon will depend on several factors:
- How long you make the loan for (ie the period to when you get your money back)
- How risky the company or government is thought to be (ie how much risk is there that you the company or government might not be in business by the time your money is due to be repaid
Typically, the longer the period of the loan, and the riskier the company/government is, the higher the interest or coupon. In other words, to reward you for the greater risk you are taking with your money, you receive a higher interest payment.
As a bondholder, you will not get a share in the profits of the company, but you are not as exposed to losses as a shareholder, provided the company/government does not completely fail.
You can still lose money on bonds as the price of your bond does go up and down depending on the factors mentioned already.
The price of your bond reflects the price at which you could sell your loan to another investor if you need your money back before the end of the loan period. The price depends on a number of factors and how they compare to the situation you first made your loan:
The general market view as the strength/viability of the company.
- The better the market view of your company/government, the less chance you have of not getting your money repaid at the end of the loan term, so the bond price will increase as your loan will be more attractive to other investors.
The general market view of the sector in which your company/government operates.
- In other words, if the market views the sector negatively, the bond price may fall, even if the company is doing fine, as the risk of the company failing has increased a bit.
The general market view of the geographical area in which your company/government operates.
- In other words, if your company operates solely in the UK, and the UK outlook is not so good, the bond price may fall even if your company is doing fine.
The general market view of the global economy.
- In other words, if the market views the outlook for the global economy to be poor (eg 2008 financial crisis), the price of your bond may fall, even if the underlying business is still doing fine.
The general market view on inflation and interest rates.
- If the outlook for inflation increases, your fixed interest payments will not be as valuable, and neither will the return of your money at the end of the loan period, so the price of your bond may fall.
- If the outlook for interest rates increases, again your bond may fall, as the fixed interest rate you have agreed will look less attractive compared to others available at that time.