A bond is simply a loan between two parties.

A person who buys a bond is the lender of money at a fixed rate of interest. The borrower is the organisation, which issues the bonds. Issuers are usually government bodies or large corporations.

Organisations issue bonds as one way of financing operations – the Australian government has used bonds to fund road projects.

Like any loan, the borrower must attract investment by offering interest on money lent. Bonds are issued with a guaranteed fixed interest rate for a set period of time.

When that period expires, the investor’s original capital investment is returned. The original investment is known as the “face value” of the bond. The interest rate is known as the “coupon”.

The date of expiry is known as the “maturity date”.

For example, on 1 July 2010, the Australian Government issues a 10-year bond with a face value of $1000 and a coupon of 5 per cent.

The bond owner will receive an interest payment – paid by the Australian Government – of $50 per year (5 per cent of $1000) for the next 10 years.

On 1 July 2020 the investor will be paid back the bond’s face value of $1000.

Once issued, bonds are traded on an exchange and purchased or sold by individual investors, fund managers and other institutions. The price of the bond may change depending on demand and supply of buyers and sellers in the market.

How do bonds work?

A bond’s price may change when it’s traded on an exchange but its face value, coupon and maturity always remain the same.

Any change in price will also change a bond’s yield – or the return on the bond based on its current price.

For example, a bond with a face value of $1000 and a coupon of 6 per cent (or $60) has a yield of 6 per cent. This is determined by dividing $60 by $1000.

But if the price of the bond rose to $1200 investors would still receive a coupon of $60 – pushing its yield back to 5 per cent ($60 / $1200). If the bond was to fall to $600, the yield would rise to 10 per cent ($60 / $600).

This explains why a bond’s yield falls when its price rises, and why its yield rises when its price falls. It also explains why a bond investor who sells prior to the maturity of the bond may experience a loss on the capital value of their investment if long term interest rates rise. Conversely they may sell at a gain if long term interest rates fall.

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Liam Shorte B.Bus SSA™ AFP

Financial Planner & SMSF Specialist Advisor™

Tel: 02　98941844, Mobile: 0413 936 299

PO Box 6002 BHBC, Baulkham Hills NSW 2153

5/15 Terminus St. Castle Hill NSW 2154

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