Investing: What are bonds?

Bonds are different from stocks because a bond is a debt instrument. You receive annual interest on the amount you lend to a company in this form. At the end of the term, the company buys back the bond for its face value. In the meantime, however, you can sell your bonds on the stock exchange. The stock market value is determined by the difference between the interest rate and the interest before the bond is paid out. The risk depends on the type of bonds.

Bonds: something other than shares

A share is a piece of ownership in a company. When you buy a share, you actually buy a piece of the company in question. This is also the biggest difference between shares and bonds. A bond is a debt note: by buying a bond, you lend money to a company. The bond has a nominal value on which the owner receives a fixed annual interest rate every year. At the end of the term, the nominal value of the bond is repaid. In the meantime, the price value of the bond can change.

Bond Risk

It is often thought that bonds are an almost risk-free investment. There are indeed bonds that carry very little risk. In general, however, it is not true: the price value can rise and fall considerably. This is because you receive a fixed interest rate for bonds. When the variable interest rate (which you receive on a normal savings account) falls, it becomes more attractive to buy bonds and the price rises. When the variable interest rate rises and you receive more interest on a savings account than by owning bonds, many people will want to sell their bonds and the price will fall. At the end of the term, you will be repaid the nominal value – and not the market value – of the bond. If you can wait that long, you know for sure what you have. This does not apply to perpetual bonds. Because they last forever. In addition, you know in advance how much interest you will receive each year. This is in contrast to the payment of dividends on shares, which depends on the fortunes of the company. There is always a small chance that the interest and/or repayment cannot be paid by the company. If the company runs into financial problems or goes bankrupt, the bondholders do have priority as creditors over the shareholders, but it may still happen that they are deprived of (part of) their money.

The relationship between interest rates and bond prices

As noted above, bonds have a fixed interest rate (on the face value). When the variable interest rate falls, the price of bonds will rise; if the variable interest rate rises, the price of bonds will fall. However, that’s not all. Even when interest rates are expected to rise, bond prices will fall. Bond prices, just like share prices, respond not only to concrete developments, but also to speculation. In terms of price value, longer-term bonds respond more strongly to all kinds of developments than shorter-term bonds. The shorter the term of the bond (still), the closer the price value comes to the nominal value. The bond will eventually be repurchased for that amount by the company that initially issued the bond. Just before that happens, no one will want to sell the bond for much less than its face value; and no one will want to buy the bond for much more than its face value. After all, there is little time left to receive interest from the bond: whether the interest rate is high or low makes little difference. In this way, the nominal value and the stock market value are, as it were, drawn together.

Different types of bonds

The story above is about bonds in general. In practice, there are many different types and variants of bonds. For example, there are profit-sharing bonds that not only pay interest, but also a profit distribution. This makes these bonds quite similar to shares. On the other hand, there are also savings bonds: bonds for which a predetermined compensation is paid out in addition to the face value at the end of the term. Savings bonds are therefore bonds that are quite similar to a savings deposit.

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