What is a bond?
Bonds and shares are probably the most well-known products on the stock market. But what exactly is a bond? And what is the difference between a share and a bond? We set out the pros and cons of a bond investment below.
What is a bond?
When you buy a bond, you are actually lending money to a company or a country. In return, you will receive annual interest. After a certain period, the bond expires and you will normally get your lent money back.
If the bond is issued by a company, it is called a corporate bond. If it is issued by a country, it is called a government bond, also known in Belgium as ‘state notes’. There are also savings certificates in Belgium, where you effectively lend money to a bank.
What is the difference between a share and a bond?
When you buy a share, you are not lending money, but actually become a part-owner of a company. A share has no maturity or expiry date, nor does it offer a fixed return. If the company whose shares you have bought decides to share its profits with its shareholders, you will either receive an immediate dividend payment, or you will receive additional shares to the equivalent value of your dividend. This is called 'capitalisation'. In the latter case, you only really receive your return when you sell your shares again.
Another key difference between shares and bonds is 'volatility'. The value of shares fluctuates much more than bonds. And in many cases their values move in opposite directions: when shares fall in value, the value of bonds rises. And vice versa. Therefore, many investors choose to diversify their portfolio by investing in both shares and bonds. Another option is to invest in an investment fund that combines shares and bonds.
What returns do bonds offer?
Perhaps the most important reason to choose bonds is that they generally guarantee a fixed return. That means you know in advance exactly how much interest you will receive every year or every six months. Moreover, that interest is usually higher than the interest rate earned in a savings account.
There are a few bonds which do not offer a fixed return. Instead, they offer a variable return, which is linked to the market interest rate.
What are the drawbacks and risks of bonds?
The bond issuer is the party - a country or company - to which you effectively lend money in exchange for a bond. What happens if that country or company goes bankrupt? In that case you will be at the end of a long line of creditors (but ahead of the company’s shareholders). In practice, it will be difficult to recover your investment.
A bond can be listed on a regulated market. However, this listing does not guarantee the development of an active market to facilitate trading in that bond. A bond’s ‘liquidity’ is often provided by a professional counterparty acting as a buyer or, if necessary, seller.
Investors wishing to resell their bonds before the final maturity date will have to sell them at a price determined by the professional counterparty. This calculation will be based on the prevailing market conditions at the time, which means the price could be lower than the original purchase price.
If you invest in bonds denominated in a currency other than the euro, you risk losing some of your money if the exchange rate is unfavourable at the time you want to convert your money back to euros.
There are always general risks involved in investing. Interest rates and exchange rates can change quickly. Companies, and thus bond issuers, are also not protected from all the possible surprises that markets can trigger. All forms of investment involve a certain amount of risk.
In the case of 'callable bonds', a company can choose to redeem your bonds early. You will then receive your initial capital plus the interest that has accrued up to that point. Not a bad deal, you might think: you have your start-up capital as well as your profits. Simply reinvesting the money might seem to be the best option. However, you might find that interest rates are now a lot lower than when you bought the previous bonds. Where you might have been guaranteed a return of 10% per annum a few years ago, for example, you might discover that bonds are now only offering a 4% return. That adds up to a big difference by the time you come to the end of your investment. To compensate for this risk, the issuer’s right to early redemption usually comes with a slightly higher coupon.