A bond or fixed interest security is an instrument of debt issued by a company or government that is repayable after more than one year. Whereas owners of equity have the right to a company's assets, bondholders are effectively lending a company money and so own its debt. In the event of the company falling into trouble and declaring bankruptcy, the owners of the bonds get priority over the equity holders for any assets that may be available to these two types of investors.
Investors may normally associate bonds with low risk and low returns, and equities with higher risk and thus potentially higher returns. For investors who diversify their portfolio of funds using bonds, they will notice that returns from their bond funds fluctuate less than their equity funds. So why are bonds less volatile than equities? The answer lies in the difference between these two asset classes.
Bondholders are lenders to a government or company that issues the bond. Bondholders are entitled to a coupon payment, which can either be paid semi-annually (once every six months) or annually. When the bond matures, the investor will get back the full principal amount. For example, if you have purchased a 4% coupon bond with a principal value of £1,000, you will receive £40 annually. At the end of 10 years, you will receive £1,000.
Since bonds represent loans made by investors to a particular company, bondholders are effectively creditors. They have the right of claim to assets of that company should it go bankrupt. That's why they focus on the creditworthiness of the company, or the ability of the company to finance its interest, and payment of its assets.
If a company is borrowing only a small amount, and makes more than enough revenue to finance its loan obligations, then bond investors will feel more secure in lending money to it. Companies that have valuable assets have stronger credibility with bond investors. Investors will be more willing to lend such companies money at lower interest rates. They know that even if the company runs into financial trouble, it has assets that can be liquidated to pay bondholders.
If you compare portfolios that comprise bonds with those that comprise equity funds, you will find that the former tend to be less volatile. The fundamental reason behind this is that bond investors are effectively debt holders of the company and have a claim to the assets of the company when the company goes bankrupt. Equity-holders do not have this advantage. This actually means that investors take on less risk when they invest in bonds. In addition, the volatility of bond prices will decrease when the bond is closer to maturity. As bonds mature, the debt holder will get back the full amount of the principal. This is unlike equities where prices are volatile and there is actually no guaranteed amount that an investor can get back.
Some important points to note about bonds
Less risky does not mean no risk. Bonds issued by the US and UK governments are generally taken as the least risky of any financial asset, as both of these states have always paid their debts on time and in full. Although, even here, inflation can erode the value of payments over time. These are assets investors will prefer when they want the lowest possible risk, such as when a pension savings plan is approaching maturity.
Bonds issued by companies will be riskier than those issued by governments in large, developed economies, but then they will also pay more interest. Agencies such as Standard & Poor's and Moody's are used to give each bond a credit rating. Companies which achieve relatively good ratings are sometimes called 'investment grade' and will pay relatively less interest than those with lower ratings.
At the other end of the scale are categories such as 'high yield' and emerging markets. The former are usually smaller companies, businesses with relatively new products or businesses facing particular credit pressures. Emerging market debt usually refers to bonds issued by governments of less developed countries. Although this type of bond is necessarily higher risk, they can be a useful addition to a portfolio.
Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested