Bonds are the lesser known financial investment products in comparison to stocks or forex. This is largely thanks to the fact that trading in bonds offer high level of security and low returns as compared to stocks which works in the opposite. The most important thing to know about bonds is that they work the same way as loans albeit on a larger scale and volume.
Bonds are debt instruments, as compared to stocks which are equity instruments. During bankruptcy, bond holders are given preference before equity holders. This is also known as seniority. Seniority pertains to the order of repayment in the event of a sale or bankruptcy of the issuer. As a thumb rule, senior debt holders must be repaid first before repaying subordinated or junior debt.
What are bonds
A bond is basically a debt security that works similar to an I owe you and is usually issues by government financial institutions. When you a purchase a bond you are in fact lending money to the financial institution which is referred to as issuer. The issuer then provides a bond which promises to pay the lender a pre-determined rate of interest at specified intervals during the life of the bond term and also to repay the original value of the bond, which is the principal amount or face value upon maturity date. Therefore bonds are also referred to as fixed income securities because the lender knows the exact amount of money that they will get back if you hold the security until its maturity. However, this is not a requirement. Bonds can be sold at any point in time in the run up to its maturity date.
Bonds, although they look similar to stocks is fundamentally different to stocks, in that Bonds are debt, unlike stocks which is an equity.
Example of bond payments
Trader Joe purchases a bond for $10,000 (which is the face value of the bond). This bond has a coupon of 8% with a maturity date of 10 years. This means that Joe will receive a total of $800 as interest every year until the bond matures, which in this case is 10 years. Since most bonds pay out the interest twice a year, Joe would receive two payments of $400 a year for 10 years. Once the bond reaches its maturity after 10 years Joe gets back his original $10,000.
Bonds are typically issued where in the amount required to raise the capital is beyond the means of regular banks.
Types of Bonds available
- U.S. government securities
- Municipal bonds
- Corporate bonds
- Mortgage and assets backed securities
- Federal agency securities
- Foreign government bonds
- Gilts – Government Issued bonds in the UK
Bonds – Difference between Price & Yields
Yield is an oft mentioned term when it comes to dealing with Bonds. A yield shows the returns one gets for a bond and is referred to upon maturity and known as YTM or Yield to Maturity. Yield is calculated as the value of the coupon amount by price. Yield is in most cases similar to the coupon amount or the interest rate. However when the price changes it also affects the yield.
If you purchased a bond with a 10% interest rate for $10,000, then the yield is 10%. In the event the price of the bond falls to $8000, then the yield is now at 12.5% ($1000/$8000). On the other hand if the price of the bond increases to $15,000 then the yield would now reduce to 6.6%.
From the above example, we can infer that when dealing with bonds, if the price reduces, the yield increases and vice versa. The fluctuations in yield is usually welcomed based on your position. As a buyer, you would ideally want to buy bonds when the yield is high (or in other words, buy the bonds at a lower price). If you want to sell off your bonds on the other hand, you would typically look for lower yields as they indicate an increase in the bond price.
How are bonds quoted
Bonds are generally quoted on a yield basis in the cash market. The coupon bearing securities are quoted as a percent of par to the nearest 1/32nd of 1% of par.
For example, a bond chart might read as 108’27 or 108-27. This is equal to 108% of the par value + 27/32nds, which comes together to 108.084375
The next chart below shows the inverse relation between the bond price (black) and bond yield (blue).
How to buy or speculate in bonds
In order to purchase and trade bonds you will need to do it via a bond brokerage company. A bond broker typically requires a minimum investment of $5000 and upwards. Besides a bond broker you could also check your banks as they offer this product. To invest in bonds you can visit your national treasury website which has more information on the bonds that you can buy including the maturity and the yield.
Alternately, you can also trade bond futures with a futures exchange such as the CME futures. The difference between trading bond futures and buying bonds is that in the former case, you are merely speculation on the bonds. You don’t actually own the bonds but you can make a profit (or a loss) by trading the futures derivatives of the bonds.