Bonds

When you buy a bond, you become a bondholder and lend money to the issuer for a certain period of time. In return, the issuer agrees to pay you interest on a regular basis, called coupon payments, and to repay the face value of the bond at the end of the term.

Function

A bond works according to a simple principle: the issuer puts the bond on the market, investors acquire it and thus provide capital. During the term, investors receive regular interest payments. At the end of the term, the issuer repays the nominal value of the bond.

Bonds can also be traded on the so-called secondary market before maturity. The price of a bond then depends on supply and demand, the current interest rate level and the creditworthiness of the issuer.

In connection with bonds, certain technical terms are often encountered. The nominal value refers to the amount that the issuer repays at the end of the term. The coupon is the interest rate that the issuer pays on a regular basis. The yield describes the total yield of a bond, which results from the coupon and the purchase price.

What Are Ratings and Why Are They Important?

Ratings are assessments of the creditworthiness of companies or states that issue bonds. They are awarded by independent rating agencies such as Moody's, Standard & Poor's or Fitch. A good rating (for example, "AAA") means that the issuer is very reliable and can repay its debts with a high degree of probability. A poor rating (e.g. "B" or "CCC"), on the other hand, indicates a higher risk. This is important for investors, because the worse the rating, the higher the risk of default – and the higher the interest rates that the issuer usually has to offer in order to attract investors. Conversely, a good rating usually means lower interest rates because the risk is lower. Ratings therefore help to better assess the risk of an investment.

Why Is the Maturity of a Bond Important – And How Does It Affect the Interest Rate?

The maturity of a bond describes the period of time until the invested money is repaid by the issuer, i.e. until the maturity date. It can be a few months or many years. Basically, the longer the term, the higher the risk for the investor, as more uncertainties can arise over a long period of time (e.g. economic developments, inflation, interest rate fluctuations). To compensate for this additional risk, issuers often offer higher interest rates for longer maturities, while short-term bonds tend to have lower interest rates but are considered safer because fewer unforeseeable events can occur. The term is therefore a decisive factor in the question of how much risk and return investors want to take.

Example

Let's say you invest CHF 1,000 in a bond with a 5% coupon today. This means CHF 50 interest per year. In years 1 to 5, you will receive CHF 50 each. At the end of the 6th year, you will receive the last interest of CHF 50 and the repayment of the capital of CHF 1,000. This means that a total of CHF 300 in interest will flow over the term, while your invested capital will be repaid in full at the end.

Many bonds also have a minimum denomination and fixed trading steps, such as CHF 5,000, 10,000 or 100,000; this makes it difficult to diversify in small portfolios — with CHF 25,000, you can often only buy two stocks for 10,000 shares, which increases the risk of clustering. If you want to invest smaller or diversify more broadly, you often take a bond ETF or fund.

Yield

In the case of bonds, a distinction is made between current yield and yield to maturity (YTM). The current yield is simply a coupon by the current price and shows how much interest you will receive compared to today's purchase price. However, it is only a snapshot because it does not take into account the repayment at 100% at the end or the remaining term. The yield to maturity is therefore the more sensible benchmark: it includes all cash flows – all coupons and repayment – and the purchase price. If the price is below 100%, the YTM is usually higher than the coupon (additional price gain until repayment); if the price is above 100%, it is usually lower (because it is "melted down" to 100%). Example: CHF 1,000 nominal, 4% coupon, price 95% → current yield around 4.21%, over the remaining term this results in a YTM of around 5.8%. At 103%, the YTM would only be around 3%.

Issuer

The issuer is the organization that issues the bond – i.e. the debtor. This can be a state that needs money for infrastructure projects, a company that wants to finance investments, or a supranational institution such as the World Bank. There are different types of bonds. Government bonds, such as government bonds or US Treasuries, are considered particularly safe. Corporate bonds, on the other hand, often offer higher interest rates but come with a higher level of risk. A special form is convertible bonds, which can be converted into shares under certain conditions.

The issuer determines the terms of the bond, including the maturity, interest rate, repayment modalities, and currency and volume. The creditworthiness of the issuer has a significant influence on the risk and interest rate of the bond.

Advantages

Bonds have a number of advantages for investors: regular coupons offer predictable income and – if held until maturity and the issuer is solvent – the repayment of the nominal value, which makes it easier to plan for larger expenses, for example. Their price fluctuations are usually lower than those of shares; Bonds thus act as a stabiliser in the portfolio and help with diversification because they often develop differently than equities. You can choose maturities that match the target (short for closer projects, longer for longer-term goals) and choose between coupon types (fixed, variable, inflation-indexed) to better manage interest rate or purchasing power risks. Large government bonds and many corporate bonds are easily tradable (often with tight spreads), so they can usually be bought and sold quickly. In addition, bondholders have capital priority over shareholders, which increases the chance of partial repayment in the event of an emergency. Together, this results in a reasonable, easily plannable building block for a broadly diversified portfolio.

Risk

Despite their stability, bonds are not risk-free. Key risks include interest rate risk, where rising market interest rates can reduce the value of existing bonds, and credit risk, which arises from the issuer's creditworthiness. Inflation risk also plays a role, as the real yield can be reduced by rising prices. In the case of foreign currency bonds, there is also a currency risk that arises due to exchange rate fluctuations.

Below is an example of each and a note on how to limit the risk:

Interest rate risk
What is it? Interest rate risk describes the risk that the market interest rate will change after the purchase of a bond. If general interest rates rise, existing bonds with a lower fixed interest rate (coupon) become less attractive – because new bonds now offer higher interest rates (see inverse relationship). As a result, the price of the "old" bond falls. Long-term bonds are particularly affected, as their fixed interest rate remains less competitive over a longer period of time. The longer the remaining term, the greater the price loss can be if interest rates rise.
Example: You hold a ten-year government bond with a 1.5% coupon. If the interest rate on new bonds rises to 3%, the price of your bond falls – a sale before maturity then yields less than the original purchase price.
Limit: Choose shorter durations (lower duration),
Credit risk (credit default risk)
What is it? The issuer would not be able to pay interest or repayment. A downgrade of the credit rating can depress prices.
Example: A company is downgraded from BBB to BB; the bond falls in price because investors demand higher yields to offset risk. In extreme cases, default occurs (interest is suspended, repayment uncertain).
Limitation: Pay attention to high quality (e.g. government bonds of solid countries, investment grade), diversify broadly, check issuer risks.
Inflation risk
What is it? Rising prices reduce the purchasing power of interest payments and repayments; the real yield falls.
Example: Your coupon is 2%, inflation is 3% – in real terms, you lose around 1% of purchasing power per year, despite a positive nominal yield.
Limit: Use inflation-linked bonds or choose maturities/coupons that are realistically higher than expected inflation.
Currency risk (for foreign currency bonds)
What is it? If the exchange rate changes unfavourably, it can eat up earnings or amplify losses.
Example: As a CHF investor, you buy a US dollar bond with a 4% coupon. If the USD depreciates by 6% against the CHF, your currency loss can exceed the interest rate – the bottom line is a loss in CHF.
Limit: Use currency hedging or invest in bonds of your own reference currency.

Inverse Relationship

If market interest rates rise, the prices of bonds already issued fall – and vice versa. This inverse relationship is a fundamental principle of the bond market: if the market offers a higher interest rate, older bonds with a lower coupon lose their attractiveness and thus their value. If, on the other hand, interest rates fall, the prices of these older, higher-yielding bonds rise. The chart clearly shows this correlation – as market interest rates rise, the bond price falls.