What are bonds and how do they work?

As the name suggests, a bond is an obligation. Bonds are issued by governments and companies, the issuers. The issuer of a bond receives money from an investor on mutually agreed terms and undertakes to repay the capital at the end of the term while compensating investors periodically by paying them interest during the term.

Bonds offer investors a good opportunity to generate regular and stable income. They are traded on the stock exchange, but are less exposed to price fluctuations than stocks, thus contributing to the stability of a portfolio. At the end of the planned term (referred to as the maturity date), you will usually be repaid the original amount invested, or rather, the nominal value (also known as the face or par value). The nominal value corresponds to the interest-bearing outstanding debt.

As a bondholder, you enjoy a degree of financial predictability, as you know both the current interest income and the repayment amount at the outset.

Whether you should invest more in bonds or buy stocks depends on your personal investment strategy, your individual risk profile and your investment horizon. A mix of stocks and bonds is often recommended, because the long-term potential for attractive returns from stocks and the generally stable income from bonds complement each other.

Bonds are by definition fixed-income securities whose maturity and interest rate are predetermined. To enable this “inherently rigid investment” to adapt to changing market conditions, the bond price changes – in inverse relation to interest rates. Rising interest rates lead to falling bond prices and vice versa. For example, suppose you are an investor from Switzerland and own a bond with a face value of CHF 10,000.

The fixed coupon rate is three percent and the term of your bond is 10 years. You will thus receive annual interest income of CHF 300 until the end of the term.

Meanwhile, market interest rates rise, and a comparable bond has a coupon rate of four percent, equivalent to CHF 400 in interest per year. Your bond is now comparatively unattractive because its coupon rate is below the market rate. In response, the value of your bond falls. In this way, the two bonds are rebalanced in terms of price. For you as bondholder, this decline in price is to your disadvantage, though it is positive for other potential investors.

Irrespective of this dynamic, price swings increase the longer the term of the bond. The further your bond is from its maturity date, the more sensitive it is to changes in interest rates. This sensitivity is referred to as the duration of a bond.

In the case of issuers, a basic distinction is made between governments and companies. Particularly when (Western) governments issue bonds, you can generally assume secure interest income and a secure repayment at the end of the term.

It is different for companies. Their trustworthiness is determined by the quality of their balance sheet and their earning power. Independent agencies measure this trustworthiness and summarize a company’s creditworthiness in a rating. The amount of interest paid on a bond is directly related to this rating.

If the issuer has a solid balance sheet and good profitability, you as an investor can trust that the bond will be repaid at the end of the term. As a rule, the better the rating, the lower the interest rate. If a company’s balance sheet is weak or its earnings are volatile, you need a higher interest rate for your investment to consider it attractive.

If the initial business situation changes, the assessment often changes too. For example, a company can improve its rating by reducing its debt. In turn, the rating will be adjusted downwards if, for example, the company is facing bankruptcy.

Bonds are stable and predictable investments, yet they still appeal to a broad spectrum of risk/return profiles. For example, a portfolio of government bonds with a high credit rating has little price volatility, but also pays less interest.

To get a higher return, investors must take additional risks. As a bondholder you can make concessions with regard to the term. This means that bonds with a longer term to maturity have a higher interest rate risk – but usually also higher interest payments.

Alternatively, you can focus on the issuer’s credit rating, which in turn means greater sensitivity to changes in the economy. This may affect the likelihood of repayment. The following applies here: The worse the issuer’s credit rating, the higher your interest earnings.

Bond portfolios are characterized by the fact that specific risks are eliminated through diversification, i.e., distribution across many different investments. For example, rising interest rates in the short term can be offset by falling interest rates in the long term. A downgrade or default of an issuer also carries less weight if you hold dozens or hundreds of other positions in your portfolio.

Last but not least, liquidity in bond trading can be very low. This means you can only sell bonds early if you find a buyer. In this respect, you bear the risk of holding your bond until maturity or having to sell it before the end of the term at an unfavorable price.

Do you want to invest your money in bonds but don’t know how? The first step is determining your investor profile and investment horizon. The associated investment strategy is also of great interest. Discuss your financial situation and the goal of your investment with an expert to find the right solution together.

If you choose to manage your investments yourself, you have the option to invest in bonds as a direct investment. You can either buy bonds from individual issuers or invest in bond funds. This has the advantage that you are automatically more diversified, because fund managers invest in a range of different bonds rather than individual bonds. At the same time, you benefit from the expertise and know-how of the fund specialist.

As a bondholder, you receive an agreed-upon interest payment every year. This interest earned is considered income and is taxable. If you sell your bond before the interest payment date, the accrued interest remains tax-free for you. If you sell your bond at a profit during its term, this profit is also tax-free. 

Bonds are considered stable forms of investment that offer a degree of predictability. They are traded on the stock exchange, issued by companies or governments, and their price fluctuates less than is the case with stocks. Nevertheless, they are also associated with risks and are subject to economic developments.

As part of a portfolio, they are a good way of absorbing certain fluctuations. As with any investment strategy, it all depends on your personal goals. You decide whether bonds are also an option for you.