Bonds are loans made to organisations, this could be governments, small or big companies.
An individual bond is just a part of the loan as typically these entities(companies, governments etc) raise so much money that more than one funding source( more than one lender) is required and hence one loan is divided up into multiple bonds to increase the amount of lenders by making the loan amounts smaller per lender and hence less risky.
Example: A company looking to raise £100m can offer bonds with a minimum value of £10,000 each. This means more investors can participate as they don't have to loan £100m in one go.
Bonds are a type of fixed income investment: This means they provide a guaranteed income over a fixed term.
Bonds work like any other loan. The borrower agrees to pay back the capital borrowed on a set date and pay back an agreed amount of interest yearly.
The creditors or debt holders (people who loan the money) can either wait to get all their money back or trade their bond in the secondary market. Bonds can rise or fall in value and this is why they can be traded either privately to a broker or openly on an exchange in the secondary market.The price of bonds rise based on the interest rate in the originating country and other economic factors such as stock performance.
To summarise, the key things to look for in a bond are:
The interest the bond pays
The number of times interest is paid
The length of the bond term
The amount paid back at the end of the bond term.
Types of Bonds
There are two main types of bonds, the coupon bond and the zero coupon bond.
With coupon bonds the lender lends a set amount to the borrower and the borrower makes periodical payments to the lender and at the end of the term returns the initial loan. Companies usually issue coupon bonds.
Zero Coupon Bonds:
With the Zero coupon bond the lender lends a set amount to the borrower but the borrower does not have to make periodical payments to the lender but will instead return the initial loan at the end of the term plus interest. Governments usually issue zero coupon bonds.
Advantages of Bonds:
Bonds pay you a fixed interest over an agreed time frame.
Bonds can also be resold at a higher price. This can be due to the fact that the bond presents better value than anything else(any other investments) available on the financial market
Bonds can also be added to your investment portfolio via mutual funds, this means a lot of bonds are packaged into one fund and so your money is spread across quite a few bonds. This reduces the risk of default through diversification. In contrast if all your money was with one bond and the borrower defaulted, you will lose all your money.
Bonds are typically very liquid which makes them a great investment to get in and out of.
Disadvantages of Bonds:
Bonds aren't the greatest earners, inflation could erode your interest earnings and stocks are known to earn more than bonds over a similar term.
Companies and borrowers can default on bonds. This is why the S & P rating of bonds should be taken very seriously before investing into bonds.
Bonds are priced confusingly and valuing them can be tricky. This is because Bond yields move in the opposite direction of Bond prices. So the higher the demand for a Bond, the lower the yield.
You might say, why would there be increasing demand for a low yield bond. This is simply because investors see Bonds as safer investments than stocks and as demand increases for them, the companies or Governments offering them feel no need to offer higher yields(interest rates, returns).
Not all bonds have great liquidity, you might find it hard to sell bonds with lower S & P ratings or bonds from emerging markets. A financial instrument is said to be liquid when it can easily be converted into cash.
Bonds and the economy
Bonds are a great option when the economy is doing bad as they offer a stable and typically higher return than most other forms of investments. So their prices are likely to rise in a downturn economy as demand increases for them and their yields subsequently fall.
When the economy is doing fine Bonds are less attractive and there is little demand for them which pushes their prices down and the yields higher.
Also, when interest rates rise, Bonds look more attractive and stocks less attractive However if you already own a fixed interest bond and interest rates rise higher than what you are currently receiving then your bond instantly loses value.