There are two types of bond market in some of the countries, such as primary and secondary bond market. There are also types of bond and one of the bond that I will be talking about is government bond and how it can help to control the inflation rate. Government usually produce bond to gain some capital to improve the economy, bond is very good way for government to generate capital for their investment, but it can be no use if the government spends on things that does not generate returns. Bond has maturity date and when the maturity date is expired the government must pay back the original price of bond. Usually bond has very little returns and the value of bond reduces when it gets closer to the maturity date. The reason why bond is bought by many people is because it is considered as risk free and it has coupon payment.
Why the value of Bond reduces when it gets closer to due?
The value of bond reduces as it gets closer to the due date, the reason is because the bond has a coupon payment. The coupon payments are usually made annually and the longer the maturity date of bond the longer the coupon payment will be. Lets say if a person has bond and it has maturity date of 10 years, that means he will receive coupon payments every year for 10 years. If there is another person who holds a bond with 5 years then this person will only get coupon payment of 5 years. It is better to be paid for 10 years rather than 5 years. It can also be proved by formula that the closer the maturity date the lower the value of bond.
Why the price of bond fluctuates even that it is risk free asset?
Bond is risk free asset in a long run, if the person that holds the bond does not sell their bond until the maturity then it is risk free. Usually the bond price fluctuates in the secondary market. Where bond is traded among the people, the value of bond usually dependent to the interest rate, because if the coupon payment of the bond that the customer is already holding is lower than the new coupon payment then the price of bond will reduce. The new buyers would rather buy bond that gives higher and longer maturity. Lets say there are two person John and Mike, if John has 1000 dollar worth of bond with 5 percent coupon payment and suddenly interest rate goes down, then the new coupon payment is 3 percent then Mike would be willing to buy the bond from John for higher price such as 1400 dollars. If the coupon payment goes up to 8 percent then Mike would rather buy new bond than buying Johns old bond with lower coupon payment and lower percentage. If Mike does want to buy the bond then he would buy it for less maybe for about 800 dollars or 600 dollars. The price of bond also fluctuates when the government wants to buy back their bonds or issue new bond. Therefore it is risk free in the sense that if you hold the bond until the maturity and also you can get coupon payment. Shares do not have maturity therefore you never know how much u will get after some years, but if you hold your bond until the maturity then you will get your money back.
Bond is good for portfolio
The investors will buy risk free asset like bond with their portfolio to reduce their risk by diversifying. It is not good to put all eggs in one basket therefore it is best to have a portfolio with multiple shares and risk free asset. Usually the investors will construct an efficient frontier by drawing capital market line, the portfolio will have number of shares with high risk and to minimize the risk they will also include risk free asset. It is one of the best ways to reduce risk in investment, it helps the diversify risk, if one 2 shares goes up and 3 goes down it reduces the risk of losing everything.