Bonds

A bond is a financial security that pays interest. Most bonds have a fixed life, and the principal is returned on maturity. A debenture is similar to a bond from the point of view of investors, but is legally different.

The interest rate is most often a fixed rate, but it may be a floating rate. In either case, it is expressed as a percentage of the nominal value (face value) of the bond.

Some bonds are issued at a discount to their face value so the payment at maturity is greater than the purchase cost. Zero coupon bonds pay no interest, and are therefore issued at a deep discount.

Bond prices change if interest rates or the market's perception of the credit risk changes. The interst rate sensitivity of a bond may be measured by its duration or (more accurately) its modified duration.

Bonds are issued by companies, governments (see government bonds) and other organisations. The credit worthiness of an organisation is reflected in the risk premium on the bond.

The rates on bonds issued by governments in their own currency (on which default is virtually impossible) are used to measure the risk free rate of return.

The real value of bonds may also be eroded by inflation - whereas shares give partial ownership of a real business, which provides a hedge against inflation. An exception to this are the index linked bonds issued by some governments that have interest payments and a return of principal that are adjusted for inflation.

A company may have several classes of bonds, and some may take priority over others for repayment (in the case of liquidation). Those with a lower priority (junior or subordinated bonds) are higher risk and therefore should have a higher yield. A company may also issue bonds with extra or different characteristics - the most common example are convertible bonds. Preference shares are legally shares but are economically (from an investors point of view) little different from very junior bonds.

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