Introduction to Bonds

Bonds are a form of financial securities which comes under the debt or fixed income markets. When one mentions bonds, the most famous bonds that come to mind are the US Treasuries (10 and 30 years), UK Gilts and so on. Unlike other financial markets such as the equities, bonds come under the fixed income group and usually carry lesser risk than equity or forex markets. Bonds, although might seem complex is nothing but another fancy term for an IOU. In this article you will learn about the following aspects of bonds.

  • What are Bonds?
  • How do bonds work?
  • Difference between bonds and equity
  • Why are bond markets important?

What are Bonds?

Bonds are financial debt instruments which are usually issued by Governments, Municipalities and even corporate organizations in order to raise cash. Bonds are typically issued by governmental organizations and are known as government bonds while the bonds issues by corporate organizations are referred to private or corporate bonds. Bonds are usually issued when the issuer needs to raise cash quickly in order to fund new projects or ventures. In return for this cash, the issuer pays an interest for the money loaned as well as paying back the principle amount at a fixed period of time.

Bonds are essentially issued in order to raise cash and the most notable proponents of bonds are usually governments, referred to as sovereign bonds. Bonds are raised for many different reasons; from funding an upcoming infrastructure project to even raising money to pay social benefits.

Bonds are primarily categorized into the following and each of these type of bonds carry their own risks.

  • Government Bonds (issued by the sovereign government)
  • Agency Bonds (issued by government agencies)
  • Municipal Bonds (issued by local or state governments)
  • Corporate Bonds (issued by corporate organizations)

How do bonds work?

In order to understand how bonds work, let’s use an example cited below:

Company ‘A’ needs to raise cash to the tune of $100,000 in order to fund their new market expansion. So the company decides to issue 100 bonds with a face value of $1000 each (100 bonds x $1000 = $100,000). The company promises to pay the creditors annual interest of 5% for a period of 2 years.

So 100 creditors loan $1000 each to the company. At the end of two years, each of these creditors is paid $100 in interest along with getting their initial loaned amount of $1000 back.

Bond terminology

  • Term of the bond is also referred to as Maturity
  • The interest that is paid is referred to as Coupon

Yields: Yields form an important aspect of the bond markets. Yields are nothing but the return one gets on a bond. Mathematically, Yields are calculated as follows:

Yield = Coupon Amount/Price

Ideally, Yields are (should be) equal to the coupon. Going by our earlier example where the bond has a face value of $1000 and a Coupon of 5%, the Yields would be calculated as (50/1000) = 5%

Who sets the Coupon (or interest rates)? The coupon or interest rates, especially for Government bonds are set by the markets and the creditors. Creditors usually look to credit ratings agencies such as Standard&Poors, Moody’s and Fitch to name a few which categorize bonds based on the issuer’s overall financial health. Bonds are categorized into

  • Prime Investment
  • High Investment Grade
  • Medium Grade
  • Lower Medium Grade
  • Non-investment Grade
  • Highly Speculative Grade
  • Junk Grade (Extremely Risky)

Depending on the category the bonds that are being issued fall into, creditors (or markets) can demand higher or lower interest rates.

Difference between bonds and equity

As mentioned earlier in this article, Bonds are debt instruments while equity markets are basically equity, therefore the terminology also changes. The basic difference being that when investors buy equity, they essentially become owners (or own a stake) in the company they invest in (thus the name investor). When buying bonds however, the creditors simply loan the amount at interest and thus do not have any stake or ownership in the organization that they are lending to. Generally speaking when a company or a government goes bankrupt, it is the creditors or the bond holders who are given more preference than equity holders.

Another difference between equity and bonds is that bonds usually have a maturity date after which they are redeemed, unlike equities or stocks where investors can continue to hold them indefinitely.

Why are bond markets important?

Bond markets are one of the critical markets that savvy investors always refer to in order to ascertain the financial health of a government or a corporate organization. When a country issues more bonds, it is basically borrowing more than what it earns via taxes and exports and can thus act as a barometer to the overall financial health of the sovereign. Traders often look to the interest rates that go with the bonds. Higher the interest rates, risky the bonds are and vice-versa. Bond markets usually go in the opposite direction to the equity markets. The chart below shows the relation between the US 30 year Treasury and the S&P500 to illustrate the point.

Besides the simplistic comparison above, there are other factors that influence bond market prices as well. Another easy to understand example is the returns. For example, if investors find better returns in the equity markets (which means that bond yields are dropping), the obvious choice of investment instrument would be the stocks. Likewise, in times of economic downturn, investors might find the equity markets to be risky and thus put their money in the bond markets to earn a low yet lesser risk return on their investment.

Bonds – In conclusion

If you are one of those savvy traders who especially prefer to swing trade, keeping an eye on the bond markets can go a long way in managing your investment and trading. Bond markets give a good overview of the health of the economy and the overall investor sentiment and economic cycles.

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