What a bond is
With a bond you lend money to a government or a company. You get fixed interest and your money back at the end, provided the borrower can still pay by then.
Learning objective: After this lesson you can explain how a bond works and what risk remains.
With a share you become a co owner. With a bond you become a lender. You lend money, get interest every year and your money back at the end of the term.
Safer than a stock
That's usually safer than a share. If the company goes bust, you get your money before the shareholders. In return your return is capped. If the company does brilliantly, you still only get the agreed interest.
Why bonds fluctuate
Bonds swing too, and the reason surprises many people. Hanna buys a €1,000 bond with ten years to run at 2 percent interest. A year later new bonds pay 4 percent. Nobody wants to buy her old 2 percent bond at the full price anymore. Its price falls, in this case by about 15 percent.
Holding to maturity
If Hanna holds on to the end, she needn't care. She gets her €1,000 back. If she has to sell earlier, she makes a loss. That's why the term matters so much. The longer it is, the more the price reacts when interest rates change.
A bond is nothing more than a series of payments: interest every year, repayment at the end. Its price is what those payments are worth today, calculated with the rate the market currently demands. If that rate rises, future payments are worth less today, and the further in the future they are, the less. That's all there is to interest rates and bond prices moving in opposite directions.
Duration
How sensitive a bond is shows in its duration. The so called modified duration tells you roughly what percentage the price loses if rates rise by one percentage point. With a duration of 7 that's about 7 percent. The calculation is an approximation. With big jumps in rates the loss turns out slightly smaller and the gain slightly bigger than it predicts.
Telling two risks apart
Keep two risks apart. Interest rate risk only affects the price during the term and disappears if you hold to the end. Default risk is about whether the borrower pays at all, and it stays to the very end. You can see its price in the yield gap: if a corporate bond offers 5 percent and a safe government bond with the same term 3 percent, the market demands 2 percentage points as compensation for the danger that the company won't pay. Experts call that the credit spread.
| Stock | Bond | |
|---|---|---|
| Your role | co-owner | creditor |
| Return | dividends and price gains | interest, repaid at maturity |
| Upside cap | none | capped at the agreed interest |
| In bankruptcy | paid last | ahead of shareholders |
| Main risk | the company's business | solvency and rate changes |
| Volatility | high | lower, but not zero |
| Rising rates | tend to be a headwind | push down the price of existing bonds |
Summary
- As a lender you get your money before shareholders, but your return is capped.
- When interest rates rise, prices of existing bonds fall.
- The longer the term, the stronger this price reaction.
- Common mistake: thinking bonds are risk free. Price losses and, with weak borrowers, defaults really happen.
Did you get it?
Why does a bond's price fall when interest rates rise?
Because new bonds pay more interest. The old, lower interest payments are then worth less today.
What does modified duration tell you?
Roughly what percentage the price loses or gains if interest rates change by one percentage point.
Which risk disappears if you hold to the end, and which doesn't?
Interest rate risk disappears, default risk remains.
Check your understanding
Your task
You buy a bond worth $2,000 with a 3 percent coupon and a five year term. Calculate the interest per year and in total, and what you receive in all if you hold to the end. Write one sentence on why its price falls when new bonds pay 5 percent.
Sources and further reading
- FINRA (the U.S. brokerage regulator) explains duration as a metric: for every 1 percentage-point change in interest rates, a bond's price moves roughly by its duration number in the opposite direction. View source ↗
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