Bond Markets: Bonds are a loan. When you buy a bond you are lending someone money that they promise to pay you back with interest. Issuers of bonds include governments, government agencies, local government authorities and corporations who need to raise capital to finance their operations. The U.S. bond market is the largest and some of the more well-known government bonds are U.S. Treasuries, Bunds from Germany and Gilts from the U.K. Bonds differ from typical bank loans, however, because they can be transferred from one owner to another.
The bond market is also known as the fixed income market. This is because bonds pay a fixed amount of money to the investor. Bonds are considered a more conservative investment because the investor is guaranteed their money back with interest. However, it is possible for an investor to lose their money if the issuer goes bankrupt. Given that the bodies who issue bonds tend to be government backed or corporations, the risk of bankruptcy is significantly reduced. The amount of interest paid depends on the type of bond. Junk bonds, for example, have a higher yield because of the lower credit rating of the companies issuing them. Investment grade bonds will have a lower yield but are less risky.
Important components of a bond include the rate of interest, coupon frequency and maturity.
Let’s take a $1000 bond that pays 5% interest and matures in five years. The bondholder will receive $50 every year for five years. The interest paid on a bond may be fixed, floating or indexed, perhaps to inflation. Coupon frequency refers to how often the interest is paid. It may be on an annual, semi-annual, quarterly or monthly basis. In the case of a semi-annual coupon, for example, the bondholder would receive 2.5% every six months. Some bonds are zero-coupon but sell at a discount to the face value so the yield is built into the price. The maturity is the date which the bond expires but the bond may not necessarily be held to maturity. The bondholder may choose to sell the bond prior to maturity.
Bond markets are large and participants include governments, institutional investors, traders and retail investors. While the interest paid does not change on a fixed interest bond, the price of the bond fluctuates on a daily basis. If it is a $1000 bond, for example, the face value of the bond is $1000. If the fixed interest is 5% then the owner of the bond is guaranteed $50 on an annual basis. The value of the bond, however, will vary depending on supply and demand. It may be trading at above or below $1000 on the bond market. This is known as trading at a premium or at a discount to face value.
Whether the bond is trading at a premium or a discount will affect the bond yield. The yield is the annual rate of return on the bond expressed as a percentage. It has an inverse relationship with bonds. If the price of a bond increases, the yield decreases and vice versa. Take the example of the $1000 bond. The $50 is guaranteed but if the bond is purchased for $950 the yield is actually 5.26% (50/950 x 100). On the other hand, if the bond is purchased for $1050 the yield is 4.76% (50/1050 x 100).
The current yield, then, indicates the yield of the security based on its current market value. However, it does not account for the yield for the total life of the bond or the reinvestment of the interest earned. Yield to maturity does this. It measures the annual return for an investor if they held the bond until maturity and accounts for reinvestment of interest. It is a complicated calculation but the yield to maturity will be greater than the current yield if the bond is selling at a discount (below face value or below par). The yield to maturity will be less than the current yield if the bond is trading at a premium.
Bonds and stocks also have a relationship because they tend to be inversely correlated. It is not guaranteed but typically if bonds prices are rising, stocks are falling and vice versa. Money often flows between the stock and bond markets. A clear example of this was during the financial crisis in 2007/2008. When the stock markets were crashing there was a flood of money into U.S. Treasuries. The U.S. bond market was seen as a safe haven because investors believed that the U.S. was guaranteed to repay their debt with interest. The interest was very low but investors were willing to sacrifice the potential of larger returns elsewhere for the safety of U.S. Treasuries. On the other hand, when the stock market is rising investors tend to invest more in stocks than bonds. This is because the rate of return on stocks will be better in a rising market. A well-diversified portfolio, however, will likely have both stocks and bonds.
Bonds have their own specific risks. Bond markets can fall in value just like stocks. They are also affected by rising interest rates and accelerating inflation. Let’s say an investor buys a bond paying 3% interest. A year later interest rates have risen to 5%. The 3% bond is now competing with interest rates of 5%. Why would anyone consider buying a bond paying 3% when they can receive 5%? The value of the 3% bond, therefore, will fall in order to produce a better yield. The 3% bondholder still gets the principle back if held to maturity but misses out on the opportunity to profit from higher interest rates.
Economic growth is often associated with inflation and higher interest rates and bond prices should fall in such an economic environment. Professional investors take a keen interest in something called the yield curve. It is a graph plotting the relationship between the interest rate and the time to maturity of bonds. A “normal” yield curve usually slopes upward. An investor who lends money for 10 years is taking more risk than someone lending money for one year so one would expect a better interest rate. They are locking their money up for a longer period. A normal yield curve indicates a healthy economy because a growing economy will typically be accompanied by rising interest rates. The yield curve can also be inverted or downward sloping. This indicates that investors believe that interest rates will be cut in the future. Lower interest rates can help to stimulate the economy. If the yield curve becomes inverted it can indicate the onset of recession. The yield curve, therefore, is important because it is a benchmark of investor sentiment about the future of the economy.
Investors and traders may use Fundamental Analysis, Technical Analysis Indicators and Chart Patterns to
aid their decision making in the bond markets. Bonds can be purchased through a
broker or investors can gain exposure to the bond markets through Exchange Traded Funds, Futures Trading, Options, Contracts for Difference (CFDs) or Spread Betting.