Bonds are a loan to a company or a government for a set amount of interest for a set amount of time.
For example Tesco might issue a bond for 10 years at 4%. This means that the buyer of £10,000 of these bonds lends Tesco £10,000 for ten years. During the ten years, Tesco will pay the investor 4% per year, or £400, and at the end of the ten years, the £10,000 will be returned to the investor
The creditworthiness of the company is important as a company that is seen as more risky (with a lower credit rating) will have to offer a higher interest rate to attract lenders.
During the ten years, the bond can be bought and sold. The price will depend on how the interest rate compares with interest rates more widely. For example if interest rates are low, the bond will be relatively attractive and the price will be higher than the £10,000 initially paid.
If the credit rating of the issuer changes, the price of the bond might also change. For governments, bonds are the main way they can raise funds without increasing taxes. The UK treasury issues bonds which are known as gilts – (they are called this as in the past the paper bonds were gilt-edged.)
As a class, bonds are usually less risky than shares. This is because interest rates do not change on a day-to-day basis, although a shift in interest rates will affect all bonds. Like shares, individual bonds are generally more risky than a portfolio of bonds, and it is possible to buy a bond fund representing a large collection of individual bonds.
Read more about bonds, what they are and how they work on the Nutmegonomics blog.