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Explained: What is a bond and how does it work?

Have you ever wondered what a bond is? Then, read on. Alejandro, our portfolio manager, broke it down for you to broaden your knowledge.

It’s been a rough year for bond prices. The German government’s 10-year bond is down about 10%.

So, let’s explore what a bond is and how it works.

A bond is essentially a loan you give to a government, company or other entity. In return, you receive interest and expect full principal repayment when the bond matures (ends).

A bond is usually low-risk because you are promised repayment (unlike a stock, where you’re not promised a return of investment).

You can sell a bond in the market at any time before it matures, but no price is guaranteed in this case.

Let’s use an example. Please keep in mind that the math is not this round and nice, but let’s keep it simple for illustrative purposes.

Today you buy a brand-new bond issued by the German government:

Bond price at beginning = €100

Bond interest rate = 1% fixed annually

Bond maturity = 10 years

Bond price at maturity = €100

You invest €100 and if you hold the bond for 10 years, you’ll receive interest of 1% (so €1) annually for 10 years. At the end of 10 years, Germany pays you back €100.

But throughout those 10 years, the bond price will move up and down. If market interest rates fall, the bond price rises. If interest rates rise, the bond price falls. Why?

Imagine the day after you buy that bond, inflation rises by a lot…by so much that now investors decide German bonds should pay a 2% annual interest rate instead of 1%.

You immediately want to sell the day after you bought. Germany won’t repay until year 10, so you look for a buyer in the market.

But your bond’s rate is fixed at 1%, meaning no buyer will pay you €100. Since the new buyer wants 2%, the bond price becomes €90. A 10% loss! Why?

Germany will still repay €100 to whoever owns the bond 10 years from now. So if the new buyer pays €90 today and receives €100 in 10 years, that’s a price appreciation of €1 or about 1% per year. Remember the bond also keeps paying the fixed interest of 1%. So if the new buyer adds her appreciation of 1% plus the fixed interest of 1%, she gets to that magic number of 2% per year!

Back to the real world. Germany’s 10-year interest rate has risen from -0.18% to 0.90% this year, so its bond price has fallen by about 10%.

To be clear, getting paid back at maturity is never a 100% guarantee as the bond issuer can go bankrupt and not pay. In the case of Germany, the risk of this happening is extremely low. However, the risk could be much higher with, say, a company with weak finances.

Meaning it’s important to understand the credit (bankruptcy) risk of the issuer. Sometimes bonds have other funky features like adjustable interest rates, an option for the issuer to re-buy before maturity and currency risk, among others. Make sure you understand all these risks before investing!