What are bonds, and how do they work?What are bonds, and how do they work?

Bonds are used by governments, councils, banks, and companies to raise money. For investors, they can offer regular income, diversification, and a way to balance some of the ups and downs that can come with shares.

Let’s unpack how they work.

Bonds, in a nutshell

A bond is basically a loan.

When you buy a bond, you’re lending money to an organisation, known as the issuer. In return, the issuer usually agrees to pay you interest over time and repay the original amount at the end of the bond’s term.

For example, a company might issue a bond with a face value of $1,000, a 5% annual coupon, and a maturity date five years away. If you buy that bond, you’d expect to receive $50 of interest each year, and your $1,000 back at maturity—assuming the company can meet its obligations.

How bonds help companies raise money

Companies generally raise capital in two main ways: debt or equity.

Debt means borrowing money. A company can borrow from a bank, or issue bonds to investors. Bondholders are lenders, and the company agrees to pay interest and repay the loan.

Equity means selling ownership. When a company issues shares, investors become part-owners of the business. Shareholders may benefit if the company grows or pays dividends, but they also share in the company’s risks.

Key bond terms to know

• Issuer: The organisation borrowing the money—such as a government, council, bank, or company.

• Face value: The amount lent to the issuer which they agree to repay at the bond maturity date.

• Coupon: The interest paid by the bond. A $1,000 bond with a 5% annual coupon pays $50 a year.

• Maturity Date: The date the bond is due to be repaid.

• Price per $100: Bonds are quoted as a price per $100 of face value, which will fluctuate as market conditions change. For example, a bond priced at $98 is trading at a slight discount to its face value.

• Yield to maturity: An estimate of your annual return, as a percentage, if you bought the bond today at its current market price and held it until maturity. It assumes all coupon payments are made in full and on time. Because it’s based on current market price, the yield to maturity can change over time.

Where are bonds traded?

When bonds are first issued, investors can apply to buy them on the primary market.

After that, some bonds can be bought and sold between investors on the secondary market. In New Zealand, listed bonds trade on the NZX Debt Market, also known as the NZDX.

Not all bonds trade on an exchange. Many bonds are traded over the counter, through brokers and financial institutions.

Because bonds can trade before maturity, their prices can change. If you sell a bond before it matures, you might get more or less than you paid for it.

Why do bond prices move?

Bond prices can move for a few reasons.

One of the biggest is interest rates. When market interest rates rise, existing bond prices often fall. When interest rates fall, existing bond prices often rise.

That’s because investors compare existing bonds with new ones. If new bonds offer higher interest payments, older bonds with lower coupons may become less attractive.

Bond prices can also be affected by credit risk—the risk that the issuer can’t pay interest or repay the bond—and liquidity, which is how easy the bond is to buy or sell.

Why hold bonds in a portfolio?

Bonds aren’t better or worse than shares. They just do a different job.

Some investors hold bonds because they can provide:

• Regular income: Many bonds pay scheduled interest.

• Diversification: Bonds and shares don’t always move in the same way, so holding both may help spread risk.

• Potentially lower volatility: High-quality bonds have generally had smaller price swings than shares, though their prices can still fall.

• A fixed repayment date: Most bonds have a maturity date, which can make them useful for investors planning around future costs.

What are the risks?

Bonds are often seen as lower-risk than shares, but they're not risk-free. Here are the main risks to be aware of:

• Credit risk: the issuer might struggle to make interest payments or repay your principal at maturity. This is sometimes called default risk.

• Interest rate risk: if interest rates rise after you buy a bond, the fixed coupon rate can look less attractive to other investors, which can push the bond's market price down. This matters if you want to sell before maturity.

• Inflation risk: if inflation rises, the real value of your fixed income payments decreases over time.

• Liquidity risk: some bonds are hard to sell before maturity, and you may not be able to exit at the price you want.

What happens to bonds if something goes wrong?

If a company runs into financial trouble, bondholders are generally paid back before shareholders. This is called the order of priority, and it will depend on the bond’s terms. This means bonds can sometimes carry less risk than shares in the same company, but it doesn't mean you're guaranteed to get your money back.

Before investing, it’s worth reading the product disclosure statement and understanding the bond’s terms.

The main takeaway

A bond is a way for governments, councils, banks, and companies to borrow money from investors.

For issuers, bonds are a way to raise capital through debt rather than equity. For investors, bonds can offer regular income, diversification, and potentially lower volatility than shares.

Like any investment, bonds come with risks. The important thing is understanding how the bond works, how it could make or lose money, and how it fits with the rest of your portfolio.