The bond market is at times a little bit complicated for most people to comprehend. This article seeks to break down how the bond market works so as to make it more understandable to potential and existing investors.
Contents
To start off, it is important that we understand the definition of a bond. A bond is an instrument of investment representing a loan given to a borrower with a fixed rate of return.
A bond market is an avenue that issues debt securities for investors to buy. The bond market is very stable compared to the stock market. Bonds are the safest investment with the lowest risk.
Though yield and interest rates may fluctuate overtime, they are more reliable compared to stock prices.
Terminologies in the bond market
The bond market does not have many technical terms, but there are some popular terms that you should be familiar with as an investor in order to understand how the bond market works.
These are the most commonly used terminologies in the bond market.
- Maturity. This is the date when an investor should have his bond repaid.
- Yield. It consists of the total profit generated by the bond when it matures.
- Coupon. It is the percentage offered for a bond annually. It may vary by years.
- Face value. Refers to the value of the bond when it matures or the value used by an issuer to calculate the rates.
- Premium. A bond value higher than its face value.
Types of Bonds
Bonds are different with varying rates, term periods, and issuers. There are different types of bonds; this article discuses some of the most popular bonds.
- Corporate bonds
These types of bonds are normally issued by corporations to both institutional and retail investors. Corporate bonds aid companies make big purchases or new business investments like acquisitions and mergers.
- Treasury bonds
Issuance of this type of bond is by the federal government. This is the safest type of bond since you are sure to return your principal amount and the fixed rate no matter the current economic temperatures. Treasury bonds come in the form of notes, TIPS, bonds and T-bills.
- Municipal bonds
Counties, states and cities issue these types of bonds. Normally, they fund the development of infrastructure or in other major investments.
Buying and selling of bonds
You can buy bonds in 2 primary ways; either through a broker or directly from the issuer. The procedure compares to buying stock in a firm. The coupon rate of bonds is always fixed; however, they keep on changing from time to time over the years due to inflation.
For instance, if the general interests of stocks rise when the interest of the bond is still fixed, it’ll mean that the issuers will have to lower the price of the bond to make it more attractive to purchasers.
When buying bonds, you can invest in either short or long-term bonds. With the latter, you can take advantage of the fluctuating coupon rates and can earn more with high rates, unlike a long-term with a fixed rate.
Similar to stocks, it is also possible to buy and sell bonds on an open market. You don’t have to wait for the maturity date to sell your bonds. As a matter of fact, the bond market is wider compared to the stock market.
What causes a move in the bond market?
A change of expectation on inflation and the growth of the economy define a move in the bond market.
Contrary to stocks, whose earnings are usually determined by market prices, bonds have a fixed rate for a specified period. Investors make the decision on the amount of payment for a particular bond depending on their inflation expectations.
If investors expect high inflation, they buy the bonds at a lower price. If inflation expectations are low, then investors pay more for the bonds.
The primary roles of the bond market
- It is a form of financing for major long-term innovations and ventures.
- Bonds are also useful for firms to make big investments or paying for procurement as an alternative to debt accumulation from loaning institutions.
- Also, governments use bonds to finance expensive development projects.
- The bond market is vital in guaranteeing investors and issuers, financial stability.
Can you lose money in the bond market?
Bonds are often viewed as a less risky venture. However, that does not mean that one can not make losses.
It involves risk like any other investment, though its risks are very minimal. There are various ways you can lose money in the bond market, some most investors are familiar with and others are barely known.
This article features some of these ways:
- Loses in trading
Trade losses can occur for a variety of reasons.One is fluctuating interest rates. When the stock interest rates increase, then the prices of the bonds are low. Failure to properly analyze the market will cost you greatly in this situation.
Furthermore, if the company’s credit ratings fall, the company is likely to lose money because most investors will avoid it.
In some cases, restructurings in a company can affect its financial performance that will amount to loss on the side of the investor.
Liquidity loss is also a major loss factor on the side of the investor. This is because of a lack of clarity on particular issues, for example the bid-ask spread.
- Inflation
Inflation decreases the purchasing power of a bond, leading to loss of money. On the other hand, deflation makes it hard for companies to earn money for their investors.
Inflation also affects the calculation of the Consumer Price Index, which can change, though not a common situation. These changes can bring about loss. In addition, high taxation due to inflation will lower the yield of the bondholder.
- Bond funds
Bond funds are either lost through poor management of assets or redemption. When the company administration makes the wrong investment with poor returns, it will lead to significant loss.
In addition, in a situation that may result in redemption, such as corruption, the firm must sell its remaining valuable assets to fund the investors.
In such circumstances, it is almost definite that the investors will make a loss, especially if the assets are illiquid.
- Foreign Bonds
Foreign bonds can also cause losses in a variety of ways.One is due to fluctuations in currency rates.
You will earn less than what you invested in if the currency of your state and the foreign state are not doing so well. Also, rising rates in foreign countries can lead to lower prices of bonds and, in turn, lead to a loss.
State regulations that limit the buying and selling of currencies can make you lose your foreign bond. Furthermore, high taxation in a foreign country can take up a chunk of your yield, leading to the loss of your bond.
- Municipal Bonds
One way in which you can lose your money on a municipal bond is through a decrease in taxes. Taxes are a major source of income for the states and counties. A reduction in the tax rates can negatively impact on investors’ bond money.
Furthermore, a change in the laws governing the specific investment made by municipal bond funds may have an impact on your municipal bond investment.
Conclusion
The bond market is a tough field for investors of all ages, income brackets and experience, as is the choice of whether to invest in bond funds or individual bonds.
No matter what you do, knowledge of the bond market is the key. For this reason, ensure you educate yourself on all factors of the market before making an investment.