What is Bond Trading and How does it work?

When you hear the word "investment", what comes to mind? Stocks? Real estate? But have you ever considered bonds? Let’s see how bonds can become one of the potential instruments in your investment portfolio to manage risks and generate returns.

What are Bonds?

At its core, a bond is a loan. But instead of you borrowing money from a bank, a company or government borrows from you. In return, they promise to repay the principal amount at a specified maturity date, along with periodic interest payments. Consider bonds as IOUs between the lender (you) and the borrower (the company or government).

Why Invest in Bonds?

Portfolio Diversification:

While stocks offer growth potential, they are more volatile and riskier. Bonds can balance this out because of their low correlation to other asset classes like stocks and lower volatility. Thus, adding bonds ensures your entire portfolio doesn't take a hit when the stock market is down.

Predictable Income:

Bonds provide regular interest payments, offering a steady income stream, especially appealing to retirees or those seeking consistent returns.

Safety Net:

Bonds, especially government and treasury bonds, are often perceived as safer havens compared to stocks. They can act as a cushion during economic downturns.

Bond Market Basics:

The bond market, or the debt or credit market, is where bonds are bought and sold. It's divided into:

Primary Market:

This is where new bonds see the light of day. When entities need fresh capital, they issue new bonds directly to investors here.

Secondary Market:

Consider this a resale marketplace, where investors buy and sell bonds that have already been issued.

Bond Prices & Interest Rates:

One of the most crucial concepts in bond trading is the relationship between bond prices and interest rates. They move in opposite directions. When interest rates rise, bond prices fall and vice versa.

Risks of Bond Investments:

While bonds are generally considered safer than stocks, they come with their own set of risks:

Interest Rate Risk: A sudden spike in interest rates can lead to a dip in bond prices, potentially causing losses if you need to sell before maturity.

Credit/Default Risk: There's always a chance that the bond issuer might default on their payments.

Prepayment Risk: Some bonds can be paid off before maturity, which might affect returns if the bond offers a high-interest rate.

How Do Bonds Work?

When you buy a bond, you're lending money to the issuer. They promise to pay you periodic interest payments and return the principal amount at the bond's maturity date. Let’s understand this using an example:

Example:
Imagine you buy a bond issued by Company XYZ with a face value of $1,000, a coupon rate of 5% per annum, and a maturity of 10 years.

Face Value: This is the bond's par value or the amount you'll get back once the bond matures. In our example, it's $1,000.

Coupon Rate: This is the interest rate that the issuer agrees to pay the bondholder at a predetermined frequency, say annually or semi-annually. With a 5% coupon rate per annum, Company XYZ agrees to pay you 5% of the bond's face value every year. So, you'll receive $50 (5% of $1,000) annually.

Maturity Date: This is the date when the bond will expire, and the issuer will return the face value to the bondholder. In our scenario, Company XYZ will return your $1,000 after 10 years.

Throughout the bond's life, you'll receive your annual interest payments. If you hold onto the bond until its maturity, you'll get back your initial investment of $1,000. However, suppose you decide to sell the bond before its maturity in the secondary market. In that case, its price might be higher or lower than its face value, depending on factors like interest rate changes, the company's creditworthiness, and overall market conditions.

The Bottom Line:

Bond trading might seem complex, but it becomes a valuable tool in your investment portfolio once you grasp the basics. Whether you're looking to diversify your portfolio, earn stable returns, or find a safer investment avenue, bonds offer many opportunities.

Remember, the key to successful investing is diversification. By understanding the intricacies of bonds, bond investments, and the bond market, you can make more informed decisions and optimise your investment strategy.

Explore bond trading with Century Financials

Interview of Arun Leslie John, Chief Market Analyst with Bloomberg