Bonds can play a critical role in a well-diversified portfolio by offsetting the volatility of stocks and providing a source of steady income through interest payments. The bond market is one of the largest securities markets in the world and provides traders with multiple trading avenues.
UK Bonds Market – markets.ft.com
- Par Value: Also known as the face value of a bond, it represents the principal amount that is returned to bondholder at the end of maturity period.
- Coupon Rate: The coupon rate is the rate at which bond issuer promises to pay the bondholder on a periodic basis. For a bond with a par value $100, an annual coupon rate of 5% and maturity 10 years, the bondholder is paid $5 every year for 10 years as coupon payment. At the end of 10 years, the bond matures to pay off the face value of $100.
- Discount: Bonds do not trade at their par value, they may trade above or below it. If a bond trades at a value below its par value, it is said to be trading at a discount. A bond with a par value of $100 trading at $95 can be considered to be trading at a $5 discount.
- Premium: Bonds trading at a value greater than their par value are said to be trading at a premium. A bond with a par value of $100 trading at $105 can be considered to be trading at a $5 premium.
- Bond Credit Rating: The credit rating of a bond is the opinion of an independent rating agency regarding the ability of the issuer to pay the regular interest on the bond and finally repay the principal at maturity. If the payments are not made in full or in time then the issuer is said to have defaulted. Major credit rating agencies such as Standard & Poor’s, Moody’s, and Fitch provide ratings for these bonds which range from the highest down to the ‘junk’ category. As the quality of a bond reduces, the interest on it typically goes up to compensate the trader for the higher risk.
Interest Rates and Bond Prices
Interest rate movements and bond prices follow a negative correlation, i.e. whenever a macroeconomic benchmark interest rate (eg: the repo rate) falls, bond prices increase and vice versa. To take an example, a bond issued last year at a par value of £100 offers an interest rate of 5%, however, due to inflation in the economy, the government increases its benchmark rate (repo rate) in the current year after which market-wide interest rates go up too. So any new bonds issued after the rate hike will carry higher interest in accordance with the increased benchmark interest rate. So a £100 par value bond issued in the current year will offer a higher interest rate, say 5.25%. This makes any of the older bonds less attractive with respect to newly issued bonds and their market price tends to fall. The opposite of this happens when benchmark rates go down and the bonds issued in the past become more attractive thereby increasing their market price. This correlation between interest rate and bond prices is important for traders as it helps them to take an informed stance on price movements.
Types of Bond
Bond issued by federal/central governments: These securities are issued by central treasuries and the money raised through them is used by the government for fiscal spending. The maturity period of these bonds could be 1 year, 10 years or even more. In economically sound countries, these bonds carry the lowest default risk as they are backed by the government’s promise.
Local Government/Municipal bonds: These bonds are typically issued by municipal corporations and state governments to finance public improvement projects. Their interest is mostly exempt from government taxes and sometimes local taxes as well. The credit rating of municipal bonds is often reasonably good.
Corporate Bonds: Corporations borrow from traders through corporate bonds. Independent credit rating agencies rate these bonds and depending on the issuing company their ratings can vary from AAA to junk. Since these bonds carry higher risks than government bonds they often pay higher interest than government bonds.
Just like stock mutual funds, bond funds invest pooled assets based in a variety of bond instruments. Typically bond funds are of the following types:
Actively Managed Bond Funds: For such funds, the fund managers pick a variety of bonds to include in order to try to outperform bond indexes. These would include mutual funds and closed-end bond funds.
Bond Index ETFs: These funds track the movement of popular bond indexes in the market and their units can be freely traded on an exchange.
Speculative trading – Bond CFDs
Bond CFDs allow traders to speculate on price movements of popular treasury bonds such as US 10-year Treasury notes. They work like a derivative instrument, allowing traders to speculate on bond futures contracts without actually taking the ownership of bond itself. With CFDs, traders can amplify their exposure to relatively small price movements because of the margins at play. Some popular regulated brokers who provide platforms to trade bond CFDs are as below:
- AvaTrade – CFDs are available on 5 Year US T-Notes, 10 Year US T-Notes, 30 Year US T-Bond, Euro-Bund, Japan Government Bond
- City Index – CFDs are available for US T-note 5yrs and 10yrs, US –T bonds, UK Long Gilt, Euro Scatz, BTP Italian bonds
- IG – CFDs are available for US T-note 5years and 10years, German Bund, German Buxl, German Schatz, OAT French govt. bonds
These regulated brokers offer features such as tight spreads, excellent trading platforms, good leverage, actionable trade ideas, anytime-anywhere trading.
Bonds are essentially debt securities that offer periodic interest payments and principal repayment at maturity. They provide an efficient alternative to stocks for those traders who don’t like the risk of equity markets and are looking for a constant source of periodic income. They serve an important role in portfolio design by balancing the overall portfolio risk. Being a widely popular security they have a healthy derivative market growing around them for speculators and traders.
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