Bonds and Interest Rates Explained

A bond is a financial debt instrument that is used to raise money by corporations and governments when money is loaned to them. But you should always keep in mind that bonds are different from stocks (equities).

Bonds are also classified as “fixed income investments” because they generate money for the investor on a regular basis up until the maturity date when all financial obligations are settled.

How Bonds Work

You can think of bonds as a loan were the debtor known as a “bond issuer” goes on to offer the “bond security” to public market participants or to private investors.

The bond issuer has an obligation to repay the lender’s principal amount on the bond’s maturity date (i.e when the loan is due). However, in the meantime the bond issuer also has to pay periodic “interest payments” to the lender.

So in a scenario were you buy bonds, just remember you will be acting like a lender to that particular organisation because you will receive all your money back (i.e your principal amount or par value) including interest on top.

How You Make Money From Bonds

To understand how you get paid when you invest in bonds let’s look at the following example.

Let’s say you buy a 10-year government bond which has a face value of $10 000 and fixed annual interest rate of say 4%  this is how much you would make if you wait until the bond matures:

  • You will receive $10 000 back as your principal amount (par value) after 10 years
  • You will also be paid interest of $400 every year (fixed annual interest rate of 4% x $10 000)
  • Finally your return on investment will be $4 000 (annual interest of $400 x 10 years)

The Key Components of A Bond

The key components of every bond and these are as follows:

  • Coupon (interest rate)
  • Yield 
  • Maturity date

The coupon is a fixed rate of interest which is paid to you usually after every 6 months but depending on the conditions of the bond this can also be annually instead of semi-annual payments (every 6 months).

The maturity date is when the bond issuer will pay you a lump sum of the original amount that you spent on the bond. For instance, if you bought the bond for $100 000 the bond issuer will give you $100 000 on the maturity date and you get to keep all the interest that you received during the course of the bond.