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Bonds Explained

Bond, James Bond

No, not James Bond, the other bond. The ones the banks and governments issue.

We always hear people talking about them. We know they have to do with money somehow, but what are they and how do they work?

When People Lend Banks Money

Though bonds are slightly more complex, we can think of bonds like loans that people or companies take out.

Except now, instead of the people taking the loan, it is the bank that is loaning from an individual.

When you buy a bond, you’re essentially lending money to the person, government or bank that issued the bond. In return, they promises to pay you the amount you loaned them back, plus interest over a certain period of time.

So, you lend them money now, and you make a profit over time as they pay you back the loan amount with interest. It’s kind of how all credit works these days, except in this case, the roles are reversed.

Risk Vs. Reward

Some bonds are considered riskier than others.

For example, if you’re lending money to a company that’s struggling financially, there’s a higher chance that they might not be able to pay you back. So, if you invest in that risky company’s bonds, you might demand a higher interest rate to compensate for that risk.

Similarly, bonds with longer maturities (the length of time until the bond matures and the issuer repays the loan) also tend to be riskier, since there’s more time for something to go wrong. So, investors might demand a higher interest rate on those types of bonds too.

The Price Is Right…or is it?

The price of a bond can vary depending on a few factors.

For example, if interest rates in general are low, then investors might be willing to pay more for a bond that offers a higher interest rate. They want something that makes them more profit than just a boring savings account and they pay a little extra to potentially get more back.

But if interest rates go up suddenly or are already very high, then the price of those existing bonds which are stuck at old lower interest rates might drop. They are not as exciting and will not make people as much money as the new bonds with higher rates. This means those investments can lose money.

Different bonds have different prices and risks because they represent loans to different borrowers with varying levels of financial health and different maturities. The returns on those bonds (the interest rates) reflect those risks, and can vary depending on market conditions.

Photo credit: Bond: Rob Mieremet, CC BY-SA 3.0 NL via Wikimedia Commons