A bond is an IOU (‘I owe you’), a piece of paper or record on a computer screen that acknowledges a debt and agrees in advance how long it will take to pay back, and at what interest rate. When the alloted time (which can range from six months to over 10 years) is up, then the original sum of money is repaid in full. Interest payments (also called ‘coupon payments’) are made periodically. For example, government bonds typically pay out twice a year.
Bonds are issued by governments or corporations who want to borrow money. Bond purchasers (or ‘bondholders’) such as pension funds and banks lend the money on the grounds that they will gain interest on it as well as being returned the original sum at a later date. For example, if it is a $1bn 10-year bond with a 5% interest rate, then the bondholder would receive $50 billion per year, as well as seeing the initial $1bn repaid at the end of the 10 year period.
However, the bondholders also stand to lose their money if the repayments are not made. For this reason, the rate of interest on a bond is calculated according to how risky the borrower (the government or company issuing the bond) is perceived to be. The perception of risk is generally judged by private ratings agencies.
As companies and governments want to borrow money cheaply, they try to reduce the perceived riskiness of their bonds in various ways. One of the most obvious is to provide guarantees (or ‘collateral’).
Bond trading on today’s capital markets is often far more complex than the above description, as a result of securitization (the re-sale of complex packages of debt, or asset-backed securities, which bundle together existing loans and then re-slice them into tranches for re-sale as Collateralized Debt Obligations).
Bonds already play a key role in climate-related finance, with government bonds or project bonds funding renewable energy infrastructure. They also provide the core source of income for the World Bank (IBRD) and International Finance Corporation, which have started to offer green bonds to investors.
Various climate bonds and forest bonds also exist, with some investors and non-governmental organizations arguing that these should become a more central instrument in international climate policy.