What is a bond?

A bond is a debt certificate issued by a state, a public authority, a national or a private company to borrow funds for a defined period of time. When you subscribe to a bond, you loan money to the issuer. In exchange, you receive annual interest in the form of a coupon and the reimbursement of the principal at maturity of the bond. For example, a 10-year bond issued at a € 1 000 and with a 3% interest rate will be repaid € 1 000 at the end of the 10-year term. You recover the capital invested in the bond.

Bonds are generally fixed rate bonds: during the whole length of the loan, the bondholder receives a fixed-rate coupon, calculated as a percentage of the bond’s face value (3% of € 1 000 in the above example). Some bonds are issued with a variable coupon rate. In this case, the rate follows the evolution of money market rates indexed to inflation (the reference rate in Europe is EURIBOR). If the rates increase, the coupon will increase too. And vice versa.     

The life of a bond can range from some months to several years, as it is often the case for state bonds.

What are the advantages?

The main advantage of a bond is the fact that it generates predictable and regular income. Unlike dividends paid on stock, the bond’s return is not linked to the economic performance of the issuer. 

You don’t have to keep your bonds until their maturity date. You can sell them before if you need cash.

Bonds will give you a better return in the expectation of falling interest rates. Moreover, the interest rates on bonds are typically greater than the rates on saving accounts.

What are the risks?

Even if bonds are safer than stocks, investing in bonds involves some risks.

Issuer's default 

The issuer cannot repay the bond at the maturity date. The risk is extremely rare for high quality issuers like state bonds but a lot of things have changed since the financial crisis of 2008. Several investors consider that some states like Greece or Portugal can go bankrupt. That is why the Greek, Spanish or Italian state bond rates are so high. The rate reflects the speculative character of the bond issues and the degree of confidence in such issues.

Let’s take an example. If you buy state bonds issued by Germany, you won’t take any risk. You will receive very low return because the risk of non-reimbursement of the capital is low. On the other hand, the rate of the Greek state bonds will be higher because the investors consider that the risk of bankruptcy of Greece is higher. The risk will be compensated by a coupon bearing a higher rate of interest.

The same reasoning applies to companies. The stronger is the company’s position, the lower is the interest rate. And vice versa.

Interest rate fluctuations 

If you want to sell your bond before the maturity date, you take the risk to receive less money than the capital invested. The value of a bond increases if the interest rates decrease and decreases if the interest rates increase. During the issue period, the rate of your bond reflects current market conditions. If, later, newly issued debt securities of the same type offer coupons with a higher rate, your bond will be less attractive and its value will get lower.

There are several kinds of bonds, including convertible bonds (the holder can convert the bond into a specified number of shares of common stock in the issuing company or cash of equal value), puttable bonds (the holder of a puttable bond has the right, but not the obligation, to demand early repayment of the principal on one or more specified dates called windows periods) and zero-coupon bonds (when a zero-coupon bond matures, the investor receives one lump sum equal to the initial investment plus the imputed interest).

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