Understanding Bonds and Fixed-Income Investing.

How Do Bonds Work?

The basic structure of a bond is relatively straightforward. An issuer raises money by borrowing from investors. The bond specifies important terms such as the amount borrowed, interest payments, maturity date and other conditions.

If an investor holds a bond until maturity and the issuer meets its obligations, the investor may receive the scheduled interest payments and the principal amount at maturity. If the investor sells the bond before maturity, however, its market price may be higher or lower than the amount originally invested.

What Is a Coupon?

A coupon is the stated interest payment associated with a bond. For example, a bond with a £1,000 face value and a 4% annual coupon would have a stated annual coupon payment of £40, subject to the bond's payment schedule and terms.

The coupon rate should not be confused with the bond's current yield. The market price of a bond can change while its contractual coupon remains unchanged, meaning the effective yield available to a new buyer can move.

What Is Bond Yield?

Bond yield is a way of expressing the return associated with a bond based on its price and expected cash flows. Investors often look at yield when comparing bonds because the market price can differ from the bond's original face value.

If the price of an existing bond falls while its contractual cash flows remain unchanged, its yield can become more attractive to a new buyer. Conversely, a higher market price can result in a lower yield for a new purchaser.

Why Do Bond Prices Move?

Bond prices can respond to changes in market interest rates. When market rates rise, existing bonds with lower fixed coupons can become less attractive compared with newly issued bonds offering higher rates. Their market prices may therefore fall.

When market rates fall, existing bonds with relatively higher coupons can become more attractive, potentially supporting higher market prices.

The sensitivity of a bond's price to interest-rate movements depends partly on its maturity and duration. Longer-duration bonds generally have greater sensitivity to changes in interest rates.

What Happens at Maturity?

At maturity, the issuer is normally expected to repay the bond's principal according to the terms of the issue. This assumes the issuer remains able to meet its obligations.

Holding a bond to maturity can reduce the importance of day-to-day market price movements compared with selling before maturity, but it does not eliminate credit risk, inflation risk or the possibility that the investor may need access to their money earlier.

Government Bonds

Government bonds are issued by governments to raise finance. In the UK, government bonds are commonly known as gilts. Government securities can have different maturities and structures, and their risk characteristics depend on the issuing government and the specific security.

Government bonds are often used in portfolios because they can provide exposure to fixed-income markets and may behave differently from equities under some market conditions. However, they are not automatically risk-free in every circumstance.

Corporate Bonds

Corporate bonds are issued by companies to raise capital. Because companies have different financial strength and credit profiles, corporate bonds can carry different levels of credit risk.

Higher-risk companies may need to offer higher yields to attract investors. A higher yield should not automatically be interpreted as a better investment because it can reflect greater risk of losses or payment difficulties.

What Is Credit Risk?

Credit risk is the possibility that a bond issuer may fail to make interest payments or repay principal as required. Credit ratings can provide one source of information about an issuer's credit quality, but ratings are not guarantees.

Investors should consider the issuer's financial position, the bond's seniority, maturity, security and other relevant terms when assessing credit risk.

What Is Duration?

Duration is a measure used to assess the sensitivity of a bond or bond portfolio to changes in interest rates. In general terms, longer-duration bonds tend to experience larger price movements when interest rates change.

This makes duration an important concept when comparing short-duration and long-duration bond investments, particularly when interest-rate expectations are changing.

Inflation and Bonds

Inflation can reduce the purchasing power of future bond income and principal. If inflation rises significantly, a fixed payment received in the future may buy less than it would have previously.

Some bonds have payments linked to inflation, which can change their characteristics compared with conventional fixed-rate bonds. Investors should understand the specific inflation mechanism rather than assuming every bond provides inflation protection.