A bond is simply a loan between two parties. Bonds, also called fixed interest investments, provide you with an income return as well as diversification when combined with growth investments like shares and property. They are debt investments that pay the holder of the bond a fixed rate of income.

What is a Bond?

A person who buys a bond is the lender of money at a fixed rate of interest. The borrower is the organisation that issues the bonds. Issuers are usually government bodies or large corporations. They can also be issued by overseas borrowers, such as non-Australian governments or corporates, and these are called international bonds.

Organisations issue bonds as one way of financing operations. For example, the Australian government may issue bonds to fund road projects. The income return paid by the bond will depend on the credit quality of the borrower. Generally, corporate bonds provide lower security than government bonds and therefore offer higher levels of income return to compensate the borrower (investor) for the higher level of risk.

Key Terms Related to Bonds

Face Value: The price at which a bond is issued. This is also the amount that will be repaid at maturity, which is the date when the original capital investment is returned.

Coupon: The income return paid either quarterly, semi-annually, or annually to the investor.

Maturity: The date when the bond’s face value is repaid to the investor.

Yield: The return on the bond based on its current price.

Example

On 1 July 2018, the Australian Government issued a 6-year bond with a face value of $1000 and a coupon of 5 percent.

• On 1 July 2024, the investor will be paid back the bond’s face value of $1000.
• The investor receives a coupon of $60 each year (5% of $1000).

The cash flow for this bond is illustrated below:

• Initially, the investor pays $1000 to buy the bond.
• For each of the next five years, they will receive a coupon of $60.
• At maturity in the 6th year, the investor will receive the $60 coupon as well as the return of their initial investment (face value) and receive a total of $1060.

How Do Bonds Work?

A bond’s price may change when it is traded on an exchange, but its face value, coupon, and maturity always remain the same. Any change in price will also change a bond’s yield.

For example:

• A bond with a face value of $1000 and a coupon of 6 percent (or $60) has a yield of 6 percent. This is determined by dividing $60 by $1000.
• If the price of the bond rises to $1200, investors would still receive a coupon of $60, pushing its yield down to 5 percent ($60/$1200).
• If the bond’s price falls to $600, the yield would rise to 10 percent ($60/$600).

This explains why a bond’s yield falls when its price rises, and why its yield rises when its price falls. It also explains why a bond investor who sells prior to the maturity of the bond may experience a loss on the capital value of their investment if long-term interest rates rise. Conversely, they may sell at a gain if long-term interest rates fall.

The information contained in this article is general information only. It is not intended to be a recommendation, offer, advice or invitation to purchase, sell or otherwise deal in securities or other investments. Before making any decision in respect to a financial product, you should seek advice from an appropriately qualified professional. We believe that the information contained in this document is accurate. However, we are not specifically licensed to provide tax or legal advice and any information that may relate to you should be confirmed with your tax or legal adviser.