Bonds are a form of loan or debt issued by governments and companies, with interest paid in the form of a ‘coupon’. Bonds are issued on the ‘primary’ market before being traded on the ‘secondary’ market or directly between institutional holders.
The coupon refers to the annual rate of interest paid on a bond and is a percentage of the ‘par’ or ‘face’ value of the bond when it was issued. For example, a bond with a par value of £100 and coupon rate of 5% would pay annual interest of £5 to bond-holders.
Once the bond starts trading, its price will depend on demand and supply (explained in more detail below). A key measure is the bond’s yield, which is the interest or ‘coupon’ paid each year as a percentage of the current market price of the bond (similar to the rate of interest on a savings account).
For example, a bond might be issued at a par value of £100 with a coupon rate of 5% (or, put another way, it pays £5 in interest each year). Once it starts trading, its market price rises to £110, meaning that its yield falls to 4.5% (being £5 divided by £110).
Bonds have different maturity dates (the date on which the bond is due for repayment). These are usually classified as short-term (up to three to four years), medium-term (four to 10 years) and long-term (over 10 years).
Bonds are also given a risk rating (AAA being the lowest risk) based on the likelihood of the issuer defaulting on their bond repayment. Typically, the higher the coupon rate, the riskier the bond as investors demand a higher return to compensate them for the higher risk of default.
