Bonds are a form of debt. Bonds are loans, or IOUs; the Investor is affectively the bank
Most successful investors should carve out a portion of their retirement accounts to Bond investment – 15% or less, depending on one’s age, goals and risk tolerance – to balance out riskier stock‐based investments.
How long you hold the Bond (or how long you lend your money to the Bond issuer) also comes into play. Bonds with longer durations – say a 10‐year Bond versus a one‐year Bond – pay higher yields. That’s because you’re being paid for keeping your money tied up for a longer period of time.
Interest rates, however, probably have the single largest impact on Bond prices. As interest rates rise, Bond prices fall. That’s because when rates climb, new Bonds are issued at the higher rate, making existing Bonds with lower rates less valuable.
Of course, if you hold onto your Bond until maturity, it does not matter how much the price fluctuates. Your interest rate was set when you bought it, and when the term is up, you will receive the face value (the money you initially invested) of the Bond back — so long as the issuer does not blow up.
But if you need to sell your Bond on the secondary market – before it matures – you could get less than your original investment back.
Before delving into the world of Bonds, you are going to want to familiarise yourself with the types of Bonds available and some of the associated vocabulary.
Duration is a measure of a Bond price’s sensitivity to a change in interest rates, measured in years. Bonds with longer durations are more sensitive to interest rate changes. If you’re in a Bond with a duration of 10 years and rates rise 1%, you’ll see a 10% decline in the Bond’s price.
Coupon is another word for the interest rate paid by a Bond. For instance, a £1,000 Bond with a 6% coupon will pay £60 a year. The word coupon is used because some Bonds really had a paper coupon attached to them, which could be redeemed for the payment. Par is also known as the face value of a Bond, this is the amount a Bondholder receives when the Bond matures. If interest rates rise higher than the Bond’s rate, the Bond will trade at a discount, or below par, if rates fall below the Bond’s rate, it will trade at a premium, or above par.