A bond is a type of debt instrument issued and sold by a government,
local authority or company to raise money. Investors who buy bonds are
paid interest, which for bonds is called a “coupon”.
The entity borrows the funds for a predetermined amount of time over
which interest must be paid. At maturity, there is a final interest
payment and return of principal. The interest rate is determined by the
size of the coupon and the price of the bond at purchase. If the bond is
held to maturity, it also represents the rate of return on the
investment.
Bonds are normally issued at par values of $100 or $1,000. Its actual market price will be dependent on some combination of its duration or time until maturity, credit quality, coupon rate, and the future anticipated direction of interest rates.
The borrowed funds are typically used for capital investment projects
and to fund operational and/or financial activities, such as inventory
needs or to refinance current debt. Bond purchasers are commonly
referred to as debtholders or creditors.
Most corporate and government bonds are traded on public exchanges.
Some, however, are traded on over-the-counter markets, where buyers and
dealers exchange securities without regulatory oversight from an
exchange.
Types of Bonds
Fixed-rate bonds – The most common type of bond,
with a coupon that remains fixed throughout the life of the bond. Bond
coupons can also escalate in value throughout the life of the bond. This
extends its duration, given it pushes more of the cash flow to be paid
out at a later date, and increases its interest rate risk.
Zero-coupon bonds – Pays no interest, but generally
issued at a discount to par value (the extent of such depends on a
similarly priced coupon bond), with price appreciation common leading up
to expiration. The full principal amount is paid at maturity.
Zero-coupon bonds, both fixed-rate and inflation-protected, are issued
by the US government. These are typically called “strips”, as the
coupons are stripped out and can be traded separately from the bond
itself. Given the higher duration of these bonds, they are more volatile
than regular coupon bonds.
Floating rate or inflation-indexed bonds – Bonds
tied to some reference rate, such as a specific LIBOR rate plus a
spread, or tied to a measure of domestic inflation. Inflation and
interest rate volatility are two common risks associated with fixed-rate
bonds. To account for this, some offerings will provide protection
against these risks by offering floating (or variable) rate bonds.
Coupon rates are typically recalculated every 1-12 months. The UK was
the first government to issue inflation-indexed bonds in the 1980s. The
US issued its own inflation-protected securities (“TIPS”) beginning in
1997.
High-yield bonds – Also known as “junk bonds”. This distinction includes bonds with a credit rating
below BBB- on the S&P and Fitch scale and Baa3 on the Moody’s
scale. The credit quality of these bonds is lower due to higher levels
of financial risk that raises the issuer’s risk of insolvency. Investors
expect to be compensated for taking on higher risk. Therefore these
bonds are considered to be “high yield” relative to an investment-grade
bond.
Municipal bonds – Bonds issued by a city, state,
province, or other local government. Individuals are often incentivized
to invest in municipal bonds through their tax-free structures.
(However, this is not always true and depends on the jurisdiction.)
Convertible bonds – Under certain conditions, a
debtholder can convert a bond to a certain number of shares of the
issuer’s common stock. Because they combine debt and equity
characteristics, they are considered hybrid securities.
Indexed bonds – Bonds linked to a certain business
indicator (i.e., net income) or macroeconomic statistic (e.g., GDP).
This structure is chosen for companies that want to have greater control
over their cash flow by matching business performance with the payout
of its bonds. Some municipal bonds, known as revenue bonds, are indexed
to the revenue generated from the project the bond proceeds funded.
Asset-backed securities (ABS) – Fixed-income
instruments where interest and principal payments are secured by the
cash flows of other assets. These can include mortgage-backed securities
(MBS), collateralized debt obligations (CDOs), student loans, credit
card receivables, airplane leases, among various other assets. The
individual components to ABS are illiquid and generally infeasible to
sell individually, hence the need for securitization.
Investors look at ABS as an alternative source of fixed-income
investment and diversification. Assets are pooled and no single asset is
generally responsible for having an outsized impact on its valuation.
Issuers often lean toward the ABS structure because the process of
securitization allows them to move the underlying assets off their
balance sheets and transfer the accompanying risk to a counterparty (the
investor).
Covered bonds – Bonds backed public or private
assets, such as mortgages. Covered bonds differ from ABS in that the
assets stay on the issuer’s balance sheet.
Climate or green bonds – Bonds issued by governments
or corporations to raise funds for climate change mitigations or
environmental preservation initiatives.
Mezzanine debt – Bonds, loan debt, or preferred
stock that represents a claim on the company’s assets, only senior to
that of common shares. In the case of a bankruptcy scenario, creditors
to the company are paid back based on their hierarchy in the capital
structure.
Holders of senior debt secured by a claim to assets of the company
will be first in line, followed by junior/subordinated debt holders,
followed by preferred stockholders, and finally those holding common
stock. Because of this payout hierarchy, senior debt will have lower
returns expectations relative to capital subordinated to it, with common
shares having the highest returns expectations, holding all else equal.
In the case of ABS, where different assets are packaged and pooled
into a single security, in the event of default of some securities, the
ABS itself should still retain value, with senior tranches paid back
before subordinated tranches.
Perpetual bonds – Bonds with no maturity date. Also
known as perpetuities. These bonds issue coupon payments at regular
intervals (normally every 6 or 12 months) and will do so into
perpetuity. Some bonds that mature 100+ years in the future may also be
labeled “perpetual” given their very long-term nature.
Government bonds – Bonds issued by a central
government in developed markets are often termed “risk free” given they
are backed by the credit of the government. Given the normally solid
credit stature of these bonds, interest is generally lowest on these
relative to other fixed income instruments. Moreover, given government
agencies in developed economies run on fiat currency systems (i.e., not
backed by a commodity generally considered of value, and has value by
government decree), it is always expected that governments can pay their
debt in nominal terms to avoid default if necessary, though potentially
at the expense of inflation.
Callable bonds – Bonds that the issuer can call back
from debtholders if interest rates fall to some stipulated extent. This
is done under the premise that cheaper financing can be obtained in
lieu of the more expensive bonds currently on the market. This gives
issuers greater control over financing costs. However, investors will
generally demand extra compensation for these due to the risk associated
with these bonds being called.
Putable bonds – Bonds that can be put back to the
issuer if interest rates rise to some degree. This limits interest rate
risk on behalf of the investor. For the issuer, since they assume more
interest rate risk, putable bonds are generally a cheaper source of
financing.
Bond Trading for Day Traders
For day traders, the most convenient way to trade bonds is through
their exchange-traded fund (ETF) equivalents. Bond ETFs follow an index
that underlies the security and trades as an equity product.
These securities tend to be liquid and thus amenable for those
pursuing an active trading style. Typical bond markets tend to be fairly
illiquid or have high capital requirements in order to participate,
which makes them non-ideal or off-limits for many traders.
These days, there is an ETF for all the main types of bonds –
government, corporate, municipal, short-/medium-/long duration,
investment grade, non-investment grade, emerging markets, developed
markets, interest rate hedged, convertible, inflation-linked, variable
rate, and mostly everything in between.
ETF trading is available at virtually all brokers that specialize in stocks trading.
Main Risks
There are two main risks to bonds:
credit risk and
interest rate risk.
Credit Risk
Credit risk is derived from the potential that a
bond issuer will not have the financial means to make principal and
interest payment. Issuers, whether they be governments, corporate
entities, or municipalities, are generally rated on their credit quality
by assessing their cash flow metrics (and their stability) against
their debt load.
Interest Rate Risk
Interest rate risk boils down into two subcomponents: duration and convexity.
Duration is the amount of time it takes to reach breakeven on a
fixed-income investment. The longer a bond’s duration, the greater its
interest rate risk. Yields are inversely related to fixed-income bond
prices. So as yields rise, prices decrease.
A better measure of interest rate risk, however, is convexity.
Convexity is a measure of how duration changes with respect to changes
in interest rates. Duration, as a risk management tool, operates under
the assumption that changes in interest rates and bond yields is linear.
In reality, the relationship is non-linear and best illustrated by
convexity. The more curved the relationship between price and interest
rate changes, the more inaccurate duration becomes as a risk measure.
Mathematically, duration is the first derivative of a bond’s price
relative to interest rates. Convexity is the second derivative with
respect to how a bond’s price changes relative to interest rates, or the
first derivative with respect to how a bond’s duration changes relative
to interest rates.
Currency exchange market is known
as the market that is open 24 hours a day, but this doesn’t mean you
have to be up all day and night. While the search for the ideal trading method or system
takes up a large portion of a trader's research time, it may be worth
noting that, while these are important elements of trading, there is one
element which is arguably even more important - knowing 
A bond is a type of debt instrument issued and sold by a government,
local authority or company to raise money. Investors who buy bonds are
paid interest, which for bonds is called a “coupon”.
Safe haven assets are usually sought after by
investors to limit their exposure to losses in the event of market
downturns. There are times, such as during an economic recession, when
the downturn of the market is prolonged. When the market enters such
turbulent times the value of most investments falls 
