A bond is essentially an IOU issued by either a government, or government agency, or by a company.

As such a bond is a promise to repay a fixed amount of money on a given date in the future and to make periodic interest payments (sometimes called coupon payments), which can be either fixed or variable, in the meantime.

Sometimes government bonds are undated, that is they have no fixed maturity date, but simply offer to pay a given coupon forever.

Short dated bonds are similar to cash deposits in that they offer a return of capital in the near term. Longer maturity bonds have additional risk in that the repayment of capital becomes more dependant on the possibility of default by the bond provider, which is generally higher the longer the maturity of the bond.

Bonds are different from cash in that:

  • They can be issued by governments and commercial enterprises other than regulated banks
  • They are generally tradable securities, meaning that there is a market where one can go to buy and sell them
  • The risk of default is higher (except for government bonds) and the protection afforded if a default occurs is generally lower
  • For this reason bonds often pay a higher rate of interest than deposits.

    Finally, although bonds can be bought and sold in the market, providing a high degree of accessibility, the price of a bond can fluctuate meaning that selling a bond prior to maturity can result in a loss.

    The price of a bond is dependant on the level of current interest rates and the coupon offered on the bond. If the coupon is variable, then the price will not be as sensitive to changes in the general level of interest rates. This kind of bond is called a Floating Rate Note or FRN.

    The price of a fixed rate bond however will be much more sensitive to changing interest rates.

    Let us take an example of a fixed rate five-year maturity bond issued by a large corporation.