The financial markets have seen increased growth in the past century. This growth has led to the development of many financial products that make the industry more dynamic and competitive. Today, the number of asset classes or securities has increased. They include stocks, bonds, derivatives, commodities, currencies, ETFs, indices, options, contracts for difference (CFDs) and cryptocurrencies among others. In addition to the added securities, the financial sector has been more accessible to retail investors from all corners of the globe. For example, with CFDs, people from around the world can trade or invest in American, Asian, and European equities. This article will focus on bonds and highlight everything that you need to know to invest in them.
What are bonds?
Companies, municipalities, and governments are in a constant need for cash. They use these funds to pay staff, fund new developments, and invest in fixed assets among others. To raise this cash, these entities have a number of options. Governments can raise taxes while companies can give out more equity, borrow from banks, and even use their cash flow for developments.
Another option these entities have is to use bonds. A bond is simply a long-term debt to a government or company. The duration of the debt is known as the term-to-maturity. This maturity can be as short as one year or as long as 30 years. The interest rate for the bond is paid at specific periods. This interest rate is known as a coupon. The principle on the other hand is the total amount of the debt that will be paid at the maturity date.
There are two main markets for bonds. The primary market is the process in which the borrowers – governments, government agencies, municipalities and companies – go to the market and issue capital. The secondary market on the other hand is where the previously-issued bonds are traded. In this market, if you don’t want to hold the bonds to maturity, you can easily sell them to other people. Also, you can buy corporate and government bonds in this market.
Companies and governments issue bonds for several reasons. First, unlike equities, bonds do not affect the shareholding of a company. In other words, a debt does not dilute the ownership of the company. Second, bonds are usually long-term debts, and are often cheaper than other debt. This is because the providers of the capital are spread across the financial community. Participants in the bonds include banks, private equity, retail investors, and even governments. Finally, the bond market is usually an efficient method to raise capital because it avoids numerous negotiations.
Why invest in bonds?
As an investor, you have multiple asset classes you can put your money into. For example, you can invest in commodities, equities, and cryptocurrencies. Still, there are a number of reasons you should consider investing in bonds.
Source of fixed income: Bonds are ideal sources of fixed income. This means that if you decide to hold the debt to maturity, you will always receive a coupon at periodic intervals.
Safe investments: Bonds are said to be safer than other securities. Governments are said to be almost impossible to go bankrupt.
Bonds are liquid: If you don’t want to hold the bond to maturity, you can exit at any time at a profit. This is because bonds are usually traded in the public market.
Bonds are legally protected: If you are an equity holder of a company and it goes bankrupt, you end up losing everything. If you are a bond holder, you will get some money when the company’s assets are auctioned.
Great for hedging: When there are increased risks in the market, investors turn to bonds, which are frequently said to be safe havens. Therefore, if you believe that the economy will fall or experience risk, you can allocate some of your money to bonds.
However, a major problem associated with bonds is that their returns are often smaller than equities. This is because they are usually viewed as low-risk assets. In finance, assets that are very risky – like equities – usually attract a high return.
Risks associated with bonds
While bonds are often safer than other securities, they come with a number of risks. Some of these risks are:
Market or interest rate risk: The price of a bond usually moves in the opposite direction to interest rates. When interest rates rise, the price of a bond will fall. Therefore, when interest rates rise, and you don’t plan to hold the bonds to maturity, it means that you will see a fall in your returns. This is the biggest risk to any fixed asset investment like bonds.
Reinvestment risk: The cash flow derived from a financial security is usually assumed to be reinvested and the income from this is known as interest-on-interest. A key determinant on its amount is the prevailing interest rates. Therefore, the risk here is that the interest rates at which this cash flow is reinvested will fall. This is a risk opposite to the interest rate risk.
Timing or call risk: At times, the issuers of the bonds can call or refinance the bonds before the maturity rate. This is often done when the market interest rates decline below the coupon rate. The disadvantage for this is that it exposes you to the reinvestment risk.
Credit risk: Before a bond is issued, credit rating agencies like Moody’s, Fitch, and S&P Global are usually tasked to rate the creditworthiness of the bonds. If these agencies downgrade the country or company, it exposes you to risks.
Yield curve risk: A yield curve is the spread between the longer-term and shorter-term debts. Under normal conditions, the yield on a longer-term debt is usually higher than that of a shorter-term bond. If the spread turns negative, it is said to have flattened. This can lead to trouble for the country or company.
Inflation risk: Assume that you have bought a five-year bond with a coupon rate of 5% but then all of a sudden, the rate of inflation jumps to 7%. This means that the purchasing power of your cash flow has declined.
These are the main risks associated with bonds. However, there are more risks which include:
Political and legal risks.
Exchange rate risks.
How to use bond prices in trading
If you are an investor interested in the bond market, you can go buy or trade them in the secondary market. If you are an international investor, buying bonds from other countries and foreign companies is often very difficult.
For this reason, because the bond market has a relationship to some commodities, currencies, and stock markets, you can easily use it as an indicator of the performance of these securities.
For example, if there is a major risk in the market, the yield of US government bonds tends to rise. This happens because investors rush from stocks to find safety in the bonds. As mentioned, the market believes that the US government cannot default on its financial obligations.
At the same time, if the market is calm and the yield curve continues to flatten, investors tend to sell stocks securities. The most common metrics of the yield curve are the ten-year and the two-year US government bonds. When the spread between the two goes negative, investors believe that the economy will go through a recession or a correction. Therefore, there is usually a sell-off in stocks. A good way to take advantage of such a scenario is to short or sell the US indices which are available as contracts for difference (CFDs) in ECN brokers like OctaFx.
The same is true in corporate bonds. When the corporate bonds start to rise, stocks usually fall. This is because the bond yields rise when there is a risk of a default. For example, if you are a creditor and there are two friends who need money. Friend A is from a rich family and has a lot of assets while friend B is from a poor family and has a lot of debt. You will of course charge friend A a lower interest rate because the risk of default is low. Because friend B can default, you secure yourself by charging a higher interest rate. Similarly, bonds of a company like Apple yield lower than those of a highly indebted company like General Electric. Therefore, you can short or sell a company’s stock or CFD when you see its bond yields spike.
Government bonds are also related to currencies. When a country’s government bonds yields rise, the underlying currency tends to fall. This is because as explained above, the yields rise when investors lose confidence in an economy. As the dollar falls, safe haven currencies like Japanese Yen and Swiss Franc rises.
Similarly, the bonds have a relationship with commodities. Most commodities are traded with the US dollar. Therefore, when yields rise, the US dollar falls, and the value of the commodities rise. In addition, a commodity like gold is referred to as a safe haven. Therefore, when US bonds rise, gold also rises as investors move to safety.
Final thoughts on bonds
Bonds are very important securities that most investors should own as a source of fixed income. A traditional approach of investing is the 80-20 rule. This means that the investors’ portfolio is made up of 80% stocks and 20% bonds. However, if you don’t have access to bonds, you can use the concept of correlations to buy or sell assets like currencies and indices that are related to the bonds.