What Are Bonds?

What drives bond returns?

The total return of a bond is made up of two parts:

the price, which can move up or down, and;
the coupon payments (the income you receive - you may also see the phrase “coupon rate” used).

Coupon payments can be fixed or variable but for the purpose of this article we are focused on bonds with fixed coupon payments.

You may also hear the term yield in relation to bonds, or even its full name, yield to maturity.

Yield is an overall measure of the return that an investor expects to earn on a bond over a specific period of time. It takes into account the bond price and the coupon payments. Yield is expressed as a percentage.

Interest rate changes are one of the main drivers of bond prices and of yields. Let’s have a look at why in the table below.

	Bond Price	Yield
Rising interest rates
Falling interest rates
Explanation	There is a negative relationship between bond prices and interest rates. If interest rates increase, the coupon rate paid on an existing bond tends to become less attractive to investors. This generally causes the price of an existing bond to fall. The reverse is also true - If interest rates fall, the coupon rate paid on an existing bond tends to become more attractive to investors. This generally causes the price of an existing bond to increase.	There is a positive relationship between bond yields and interest rates. Bond yields tend to rise if interest rates rise and if interest rates fall, bond yields tend to fall.

In summary:

When interest rates rise, yields tend to rise and prices of existing bonds typically fall.

When interest rates fall, yields tend to fall and prices of existing bonds typically rise.

When interest rates go up, newly issued bonds offer higher coupon rates compared to existing ones. This usually causes the price of older bonds to decline since they're less attractive in terms of yield. On the flip side, when interest rates fall, new bonds are issued with lower interest rates than those on older bonds, making older existing bonds more valuable as their price can rise.

So, putting it all together - why can bonds be useful in a portfolio?

Income

Bonds are expected to pay interest on your investment in the form of a coupon payment, so they can provide a regular and reliable source of income.

Security

Bonds are generally considered a more secure investment than other common investments like shares, because they provide fixed interest payments, and the original “loan” is intended to be paid back in full by a set date.

Diversification

Diversification is spreading investments among and across different investments. A portfolio that contains both shares and bonds will typically have more stability than one with just shares because shares and bonds can react differently to changes in market conditions. Their prices are also less likely to move by the same amounts in the same direction at the same time. This is why we talk about the importance of diversification in investing.

Liquidity

Liquidity is the ease with which an investment can be bought or sold, without affecting its price. Compared with some other asset classes like property, bonds can be relatively cheap and easy to trade. They tend to have lower transaction costs (that is, the costs associated with buying and selling bonds).

So, while you might not see bonds mentioned often in the news, they definitely have a key role to play in a well -balanced portfolio of investments!