What are bonds?

What is a bond?

Note: Explainer video shared from investopedia's online content library

Think of bonds as a really formal IOU to the government or a big corporation.

Let’s say you have some cash in your current account and decide to lend some of your money to a company or government so they can invest in important projects like hospitals, roads, or new factories. They intend on paying you back the full amount, and will add an extra kicker to thank you for the loan every 6 months (ie. coupon) and will eventually return the full amount with an additional amount (ie. interest). As an investor, you expect a higher interest rate if there is a chance the company may be unable to pay you back. You want to get paid more for stomaching the risk of not getting your cash back. This is why a UK government bond will offer a lower interest rate than a rocket ship company on the verge of bankruptcy.

All else equal, bonds are safer than stocks because you are first in the queue to recover any losses if a company goes bankrupt. Also, bonds offer more predictable income (coupons and interest), whereas dividends from stock are never guaranteed.

A practical example:

Your friend George lends you £100 and expects you to give him back £105 in a year’s time. George expects to receive his original £100 back but also an additional £5 to compensate for the risk that you might be unable to pay him back. George really trusts you and knows you’re responsible with money so he’ll give you a lower interest rate than someone who has a history of running away with people’s money.

After 1 year, you pay back George £105 and thank him for the loan. George is happy with the extra fiver he just made. Yup- Bonds are that simple.

This explainer article is part of our ongoing education series to inform and educate the next generation of investors, by explaining key investment topics.