Bonds are rapidly taking over the global investment space, as more investors find unlimited investment options in the bonds market.
Today, not only does the bonds market run as the largest securities market globally, but it is also considered to be safer than the stocks.
Due to the complexity and the ever-evolving dynamics of the 100 trillion-dollar marketplace, the average consumer and even experts may find it hard to keep up with the pace of the global bonds market.
Within this guide, you will find a comprehensive guide on what bonds are and essential things to know about the bonds market.
What are Bonds?
Bonds are a type of loan or debt security utilized by large institutions, including governments, municipalities, and corporations. These institutions, well known as bond issuers, will sell bonds to investors in exchange for capital.
Investors who buy these bonds, on the other hand, receive periodic interest payments referred to as coupons, which are done under a consistent schedule for a fixed timeframe. Once the repayment period elapses, the bond issuer repays the principal. The stipulated time for principal repayment is known as the maturity date.
In a nutshell, a bond is a loan type where the bond issuer is the borrower, while the investors or bond purchasers are the lenders.
How Do Bonds Work?
Essentially, bonds are utilized due to the substantial figures that revolve around borrowing by corporations and governments. It would, therefore, be almost impossible for a single lender to raise the amounts of capital needed by these institutions.
As a result, multiple loans from various stakeholders (bond purchasers/investors) are packaged into one bond agreement.
For example, if the government of the UK has a project worth £10 million, it might decide to issue an offering to sell bonds in support of the project. The government might offer to sell 1,000 bonds under this agreement with a face value of £10,000 each.
Face value, in this case, is the price of the bond when it is first issued. Upon the issuance of these bonds, the government is responsible for the determination of the interest rate (coupon) of the bond based on such factors as the prevailing rates in the marketplace.
The government will also determine the maturity date of these bonds.
Which are the Categories of Bonds?
The bonds market provides multiple types of bonds that are categorized into three criteria, including the type of issuer, interest rate, and the lifetime of a bond.
Category by the Kind of Issuer
Over the years, the European bonds market has grown spontaneously, with the following types of bonds dominating the UK’s investment space.
- Government Bonds
These are the types of bonds issued by the central or federal government. Examples of government bonds across the world include the UK Gilts, Australian Treasury Bond. GSBG20, U.S Treasuries, Brazilian Government Bonds, and the Government of Canada Bonds.
Most bonds issued by local governments, such as cities, states, and provinces, also fall under government bonds.
- Corporate Bonds
Corporate bonds form the second broadest segment of the bonds marketplace. These bonds fall in the category of corporate debt, and corporations issue them in their efforts to raise capital for new ventures or expansion of operations.
Examples include the UK corporate bonds, such as Tesco corporate bonds. There are two major types of corporate bonds, namely speculative-grade and investment-grade bonds. Speculative-grade bonds, also known as junk bonds, are issued by corporations with a low credit rating and high risk of defaulting.
On the other hand, investment-grade bonds are bond types issued by companies with low credit standing.
Category by the Interest Rate
The return on investment gained in the purchase of bonds is determined by the interest earned. Here are the various types of bonds based on the type of interest rate attached to a bond.
- Fixed-rate bonds. Most corporate bonds fall under this category. These are the types of bonds that reward the same amount of interest (coupon) throughout their terms.
- Zero-interest bonds. These are bonds that do not have any interest (coupon) attached to them. Instead, these bonds are traded at a deep discount. After reaching its maturity date, the purchaser of a zero-coupon bond receives the bond’s face value.
- Floating rate bonds. These are bond types whose coupons vary with the underlying levels of interest rates. The coupon is determined by a particular reference rate which could be sourced from external rates, such as EURIBOR, LIBOR, and the Treasury Bill Rates. This means that the value of a floating-rate bond is not affected by fluctuation in the market rates.
Category by the Lifetime of a Bond
Different bonds come with varying maturation periods. There are three types of bonds based on the lifetime of each bond.
- Short-term bonds. These are bonds that mature in 1 to 3 years.
- Medium-term bonds. These bonds mature after 3 to 10 years.
- Long-term bonds. These are bonds with a maturity term of over 10 years.
How the Bonds Market is Traded?
Bond trading is a method of gaining profits by leveraging the fluctuation in the value of various types of bonds. For most investors, bond trading is a crucial element of their diversified trading portfolio, in addition to cash and stocks. Trading bonds is done in two ways;
1. Exchange Trading
Exchange-traded bonds are typically government or corporation bonds that are sold in the local currency. This is usually open to parties within the primary bonds market.
It is essential to note that bonds sold within this marketplace are usually reserved for institutions, such as investment houses and financial institutions.
2. Over the Counter (OTC) Trading
OTC trading is applicable when a bond is an open marketplace. Investors can only trade in an OTC bonds market through a third-party broker, who is an Over the Counter provider.
What are the Strategies Used to Trade the Bonds Market?
Based on the diverse roles that bonds play in one’s investment, investors have an array of trading strategies that they can use to their advantage. Bonds market trading strategies can be either passive or active, with active approaches accounting for the highest traded bond’s volume. Here are some of the strategies used in the trading of bonds.
Buy and Hold Strategy
This is a passive strategy best suited for investors looking for portfolio diversification, income, or capital preservation.
The strategy implies purchasing bonds and holding them until they reach their maturity dates. The buy and hold approach facilitates the minimization of costs as investors maximize the generation of income or profits.
Bond Laddering Strategy
Bond laddering is also a passive strategy of bonds market trading. This approach involves owning more than one bonds with varying maturities, allowing investors to maintain the income stream as they cut on costs.
In bond laddering, investors use the proceeds of a matured short-term bond to reinvest in a long-term bond.
Bond Swapping Strategy
This is one of the most active trading strategies adopted by experienced traders. Bond swapping involves the sale of one bond to reinvest in another.
Often, investors apply bond swapping to get rid of a losing bond in exchange for a better performing bond. In the long run, investors can achieve the highest volume of investment as the goal of bond swapping is to improve one’s financial position. Image.
Are Bonds a Good Investment in 2020?
For most investors, especially beginners, the big question remains ‘Is now a good time to buy bonds?’
However, while stocks continue to fall with the global outbreak, the value of bond investments have grown significantly. Here is why investing in bonds in 2020 is an ideal strategy for traders.
The Ever-growing Bond Prices
For decades, investment experts have raised criticisms on the stability of the bond market, citing high chances of a drop in bond prices.
However, the value of bonds has been on a consistent rise even when their yields have hit the lowest of records. In some countries, bond yields have run into negative numbers, forcing investors to pay bond issuers for the privilege to invest in their bonds.
Nevertheless, even with such low yields, the price of bonds is always growing. This is probably because bonds are the next best alternative to falling stocks.
A Fall in Yields Results in a Rise in Prices
When the yields of the bonds market fall, their prices rise, making bonds more desirable. This is often because the existing bonds come with higher coupons that make them more attractive when rates for new bonds fall.
The Rise of Green Bonds
In the past few years, the Green Bonds marketplace has grown tremendously, recording over $300 billion by 2019. With the G20 leaders supporting the move to scale up Green Finance, multiple flavours of Green Bonds have seen their way into the trades.
How do Beginners Invest in Bonds?
The bonds market can be confusing even to experts. Before trading in bonds as a beginner, you might want to take several factors into consideration. Here is what you will need to know.
Bonds Ratings Investing
Like any other investment, you want to know whether the bond you invest in will yield returns. If the company, government, or agency issuing bonds cannot pay for their bonds, then you will need to avoid such an investment.
To determine the capacity of such institutions to repay your investment, investors can use bonds ratings by Fitch, Standard & Poor’s, and Moody’s.
Financial Times Stock Exchange (FTSE) 100 Index
If you are planning to buy corporate bonds in the UK, then the FTSE 100 Index will be of great use to you. This index is popularly used for stock market-related matters, such as determining the most volatile stocks FTSE 100.
As a bonds market trader, however, the FTSE Index is essential as it highlights the strength of the leading companies in the UK. A beginner in bonds trading can use it to establish corporate bonds list for potential investment, as well as the corporate bond prices.
Roles of Bonds
Different investors purchase bonds for varying reasons. It is essential to set out the objective for which you intend to invest in bonds. Some of the roles of bonds include;
- Preservation of capital.
- To gain a fixed income in the form of coupons.
- Portfolio diversification.
- Cushion against economic inflation or slow down.
- Capital appreciation.
How to Convert Currencies When Trading Bonds
When dealing with bonds issued in a currency different from the investor’s domestic currency, then having knowledge on how currencies are converted is of importance. Since the exchange rate of various currencies varies with time, investors can use online currency calculators. When converting the currencies manually, ensure that you have the right exchange rate.
For example, the exchange rate between GBP and USD is 1.23. To change 5000 Pounds into USD, you will multiply 5000 by 1.23, resulting in $6150.
What Makes a Bonds Market So Attractive?
The key factors that make a bond attractive include the interest rate and bond duration.