The ChoosaBroker Trading Academy

2.8. Bonds

Once viewed chiefly as a means of earning stable income while preserving capital, bonds have evolved into a whopping $100 trillion global marketplace that offers virtually limitless investment options. Before you venture in to this huge and diverse market, it is important that you have a basic understanding of what bonds are and how the bond market operates.

What is a Bond?

A bond is a fixed income security in which an investor loans money to the issuer of the bond, who promises to pay the lender back in full, with or without regular interest payments. When a government, company or municipality requires capital to finance long-term projects, or maintain ongoing operations, they may opt to issue bonds directly to investors instead of acquiring a loan from a bank.
Along with stocks and cash equivalents, bonds constitute the three main generic asset classes. Though stocks and bonds are both securities, they differ in that a stockholder has an equity stake in a company, whereas a holder of a corporate bond has a creditor stake in the company. Except in cases of default by the issuer, investors know exactly what they will earn from a bond so long as they hold until maturity. This makes bonds an attractive investment avenue for people looking for relatively stable returns.

Characteristics of Bond

Most bonds share some basic features, the five most important among which are explained below: Issue Price – It is the price at which an investor buys a bond when it is first issued. The issuance price is typically set at the par value or face value in case of interest-bearing bonds.
  • Par Value – The par value or face value is the amount that the holder of the bond will receive at the time of its maturity. Let us assume that Company ABC issues $100,000 in bonds to raise funds. It may do so by issuing 100 bonds to the public, each with a face value of $1,000. When the bond matures, the borrower, in this case Company ABC, will pay back the lender the par value of $1,000 per bond. In the open market, if a bond trades at a price below the par value, it is said to be selling at a discount. When a bond sells above its face value, it is said to be selling at a premium.
Maturity – The maturity of a bond is the length of time before the par value is returned to the bondholder. Upon maturity, the issuer is no longer obligated to make any further interest payments. It is also referred to as the term or tenor of a bond.Maturities can range from 1 month for some local government bonds to 30+ years for some corporate securities. Bonds with shorter maturities tend to offer lower interest rates.
  • Coupon Rate – The coupon rate is the interest rate, expressed as an annual percentage of the bond’s par value, which the issuer promises to pay the bondholder. For example, if there is a 5% coupon on a bond with face value of $1000, the holder will receive $50 each year until maturity. Typical coupon payment intervals are annual or semi-annual. If two bonds with same face values and maturities pay out different coupons, the price of the bond with a lower coupon rate will be lower in open market.
  • Yield –The yield is the rate of return that an investor receives for investing in a bond. It can refer either to:
    The current yield, which is simply the annual interest payment divided by the bond’s current market price, or
    The yield to maturity, which is the total return anticipated from a bond if it is held to maturity.

Different types of Bonds and the different Issuers

Bonds come in many different configurations. Detailed below are the three most common varieties:

Federal Government Bonds – Also known as “sovereign debt,” they are the highest-quality securities available. These types of bonds are issued by national governments, with maturity dates ranging from 30 days to 30 years. Default risks vary depending on the state of the economy of the issuing country. U.S.Treasuries, U.K. Gilts, German Bunds, Government of Canada Bonds (GoCs) and Japanese Government Bonds (JGBs) are all examples of sovereign bonds. They carry some of the lowest yields around, but the default risk is also extremely low. However, in times of economic downturns, they relatively outperform other higher-yielding bonds. The interest earned by the bondholder is also generally exempt from federal income taxes.

  • Local Government Bonds
    – Bonds are also issued by state and local governments to fund the construction of highways, housing, or other important public projects. They tend to offer competitive interest rates but carry higher risk than sovereign bonds because local governments can go bankrupt. The interest earned is also typically exempt from federal income taxes and, in some cases, from state taxes also if an investor lives within the jurisdiction of the issuing state. The market for local government bonds in the U.S. is well established, where these bonds are called municipal bonds.

Corporate Bonds – Companies often issue bonds to fund a business expansion, or a large capital investment. Bonds issued by financially stable companies, who are more than likely to meet their payment obligations, are referred to as investment grade, while those issued by companies with low credit quality are called high yield or junk bonds. The yields in case of corporate bonds are higher than government securities because there is a greater risk of a company defaulting than a federal or a state government. Companies can issue bonds with either fixed interest rates or variable interest rates. Maturities can also differ. Corporate bonds are considered short-term when the maturity dates are less than 5 years; intermediate when maturities range from 5 to 12 years, and long-term instruments when the maturity dates are over 12 years.

How are Bonds priced?

Bonds do not trade like the other popular financial assets like stocks, commodities or Forex. Their pricing mechanism is different. Once a bond is issued, it can be bought and sold by the average retail investor in the “secondary market.” While some bonds trade in public exchanges, some others are transacted over-the-counter between large dealers and brokers.
In the secondary market, the price of a bond is quoted as a percentage of its face value or par value. The easiest way to understand the concept of bond prices is to add a zero to its last quoted price in the market. If, for example, a bond is currently trading at 99, its price is $990 for each bond of face value $1,000. If the bond is quoting 101, its price is $1,010 for every bond of $1,000 face value. Most bonds are first issued slightly below their face value and can then trade above, below or at par in the secondary market, depending on changes in interest rates.
Let us look at an example to better illustrate the key relationship between the general interest rate and bond prices. In a fixed-rate corporate bond of face value $1,000 and 10% annual coupon, the issuing company is obligated to pay the bondholder $100 each year. Suppose, the prevailing interest rate, as determined by the rate on a short-term government bond, is also 10% at the time this bond first begins trading in the secondary market. As such, any investor would be indifferent to investing in the corporate bond since the government bond would also return $100.
If, after a short while, the prevailing interest rate dropped to 5%, the investor could generate $50 from the government bond, while the corporate bond would still earn him $100, making it comparatively more attractive. Investors would rush to buy the corporate bond in the secondary market, bidding up its price until it reached equilibrium with the interest rate. In this case, the corporate bond’s price is likely to appreciate to $2,000 so that the $100 annual coupon represents 5%.
Contrarily, if the prevailing interest rate were to soar to 15%, an investor would be able to make $150 from the government bond and would definitely not be interested in earning the $100 coupon from the corporate bond. The market demand for the corporate bond would ease, driving its price lower to around the $666.67-mark, so that the $100 annual coupon represents 15%.

Importance of Bonds in a model portfolio

Bonds may not be as sexy as stocks or Forex, but they do have an integral place in every balanced portfolio. Let us look at some of the most important benefits that bonds lend to an investor’s portfolio:
  • Capital Preservation – Bond issuers are legally bound to repay principal on maturity. This makes them appealing to investors who want to avoid the risk of losing capital.
Fixed Income – Most bond issuers have to pay the bondholder a fixed or floating interest rate until maturity, resulting in a steady income flow.
  • Capital Appreciation – If the prevailing interest rate drops, or there is an improvement in the credit standing of the bond issuer, the price of the bond in the secondary market is more than likely to rise, generating capital appreciation for an existing investor.
  • Diversification – Since bonds often remain negatively correlated with stocks, they can cushion an investor against the unpredictable ups and downs in the equity market, reducing the volatility in a portfolio’s return.

Final few thoughts

Before you begin your bond journey, know your objectives. If you want maximum current income, high yield bonds are the answer for you. If preservation of principal is paramount, stick with investment grade bonds. Whatever be your investment target, you can’t afford to ignore bonds. If you are looking for the overall best online brokers have a look at the review section.

Ready to trade? Check out leading online brokers or get inspired by brokers that offer social trading!

Premium WordPress Themes Download
Download WordPress Themes Free
Download WordPress Themes
Download WordPress Themes
lynda course free download
download redmi firmware
Premium WordPress Themes Download