A bond is just a tradeable IOU issued by a company (corporate bond) or a government (sovereign bond). Only the fact that it’s tradeable makes it any different to a conventional loan. If a government issues a fixed-income 5% bond redeemable (repayable) in four years’ time, and is looking to borrow €100. This is the bond’s nominal value. This fixes the annual coupon (interest payment) at exactly €5 (5% of €100). The nominal value is also the amount the government will have to repay the bondholder in four years’ time.
Bond prices (like share prices) are influenced by all kinds of factors but the most important are:
1. Interest rates.
As money market interest rates rise, bond prices will tend to fall and vice versa. That’s because the relative attractiveness of a fixed 5% yield varies according to what an investor can get elsewhere. If a bank account pays 2% (€2 on €100, in other words) the bond’s nominal fixed return of €5 on a €100 investment is attractive, so demand for it will rise. This will push up the price of the bond (so you’ll have to pay more than the €100 nominal value), which in turn drives down the yield. Equally, if a deposit account pays 7%, the nominal 5% return on the bond is less attractive, so the price will fall below €100, driving up the yield.
2. Time to maturity.
The further you are from the bond’s redemption date, the more volatile the price becomes, because there’s more risk that interest rates will change while the bond remains outstanding.
3. Default risk.
Some issuers are more likely to default than others. The higher the risk, the higher the yield investors will demand. One key aspect of perceived risk is the bond’s rating. Credit-ratings agencies such as Moody’s and Standard & Poor’s are paid to rate corporate bonds – they also choose to rate sovereign bonds for marketing purposes. Their grades run from ‘AAA’ (the top rating) down to ‘D’ when an issuer is in default, so the higher the rating, the higher quality the bond.