What is a bond

Bonds are loans that can be bought and sold by investors. It’s important to note that a bond and a bond fund are two totally different investment vehicles - the focus here is on investment in a single bond. For an investor, a bond should be viewed as a loan, either to a government or a company.

In very plain terms, the borrower offers the investor an IOU, with the promise of repayment in full of the original loan after an agreed fixed period, called the maturity date, as well as periodic interest payments over the life of the bond.

Bonds are mainly split into two types: corporate bonds – issued by companies – and government bonds, for example, ‘gilts’ in the UK or US ‘treasuries’, which are long term investments, or US ‘T-bills’, which are short-term investment bonds issued for a year or less.

Governments across the globe issue bonds, with government bonds often referred to as sovereign bonds.

Bonds usually pay interest returns, also known as coupon rates, every six months or semi-annually.

So, an example of a coupon rate payment would be, where there is an expected annual coupon rate payment of 10% on the original investment, 5% of that annual rate would be received semi-annually.

Government bonds can be issued in their domestic currency or in a foreign currency. Government bonds issued in the domestic currency are less risky than corporate bonds. This is primarily because a country is very unlikely to default. A country’s government can more easily raise money through other borrowing sources or through taxation, but can also print money to pay debt obligations in their domestic currency.

Corporates however, can be at a higher risk of defaulting on paying investors coupons, or repaying investors original loans, because of potential market risk which could – for example – lead to a company becoming bankrupt.

For an investor this is called the default risk

It’s therefore vital that corporate bond investors check the credit rating of a company before making their investment, via credit rating agencies such as Standard & Poor’s (S&P): Moody’s Investor Services (Moody’s) or Fitch IBCA (Fitch), as well as undertaking further company research.

The benefit of investing in corporate bonds is, generally, the higher coupon rate received due to a higher default risk than that associated with domestic currency government bonds.