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Bonds: lending money

What a bond is, what coupon, maturity and rating mean, and why prices fall when interest rates rise.

Video lesson in preparation (AI-generated presenter). Full text below.

Lesson text

A bond is a loan. The buyer lends money to the issuer, which may be a government or a company. In return the issuer undertakes to pay interest, called the coupon, and to repay the capital on a set date, the maturity. Government bonds are bonds issued by a state.

The first risk is that the issuer cannot pay: this is credit risk. Specialised agencies give an opinion on the soundness of issuers, the rating. In general, the sounder an issuer is considered, the less interest it has to offer to find lenders; a very high interest rate usually signals higher risk. A rating is an opinion, useful but not infallible.

The second risk concerns those who sell before maturity. The market price of a bond changes over time, and it moves in the opposite direction to interest rates. If rates rise, new bonds offer higher coupons and older ones must become cheaper in order to be sold. If rates fall, the opposite happens. The effect is stronger for bonds with distant maturities.

Whoever holds a bond to maturity receives, if the issuer does not default, the coupons and capital as agreed, regardless of the price swings in between. Inflation risk remains, however: a fixed coupon is worth less if prices have risen sharply in the meantime. Bonds are therefore generally less variable than shares, but they are not free of risk.

In three points

Educational and informational content only. It is not personalised financial, investment or tax advice. All investments involve risks, including the possible loss of invested capital.

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