A bond is an IOU between an investor and a bond issuer. The issuer will normally be a Government or a company. The investor lends the bond issuer a set sum of money in exchange for a promise to pay back the lump sum at an agreed date in the future and regular interest payments throughout the term of the loan.
The ratings agencies rate companies and governments so that investors can judge how risky the bond issuer is and the likelihood of having their investment repaid at the end of the term. Generally, the less financially stable the bond issuer is, the greater the interest payment – for example the US government would pay a smaller rate of interest than a small company in a developing economy.
If you buy the bond at the date of issue and hold it for the duration of the loan agreement the interest rate is called a coupon.
Much like shares, bonds can be traded between investors. The bond issuer remains the same, but the bond is transferred to a new owner who is then paid both the interest and, at the end of the term, the lump sum.
The price of a bond is determined by the demand. While the coupon payment is a set amount of cash, because the price of the bond fluctuates in the open market, so does the yield when expressed as a percentage. Bond coupons, what an issuer has to pay to attract investors, are affected by interest rates.
As interest rates rise and fall so too do the bond yields. Usually, the price of a bond moves inversely to interest rates movements so, when interest rates rise, the price of a bond falls but when interest rates fall, the price of a bond rises.
Unlike cash on deposits, bonds are not covered by the Financial Services Compensation Scheme. The value of your investment can go down as well as up, although investors who bought at launch should have their initial deposit refunded in full as long as the issuer of the bond survives.