Characteristics of Bonds

When governments or companies look to borrow money, they don’t just always go to a bank to take out a loan or a line of credit like individuals always do. Governments never do this, and while some businesses, especially small to mid-size ones, do rely on bank lending for their borrowing needs, larger companies will often borrow by issuing bonds.

Banks make a lot of money lending out money, especially to those with very good to excellent credit ratings, where the proceeds of the loan gets paid back in a timely manner and they profit from the difference between what it cost them to obtain the money and the interest that was paid out on the loan.

Should the risk be higher, banks will charge borrowers higher interest rates to compensate for the additional default risk. All loans have a certain risk of default, even U.S. treasuries, even though the risk with them is so low that they are used as a benchmark for “risk free capital.”

The U.S. government may one day face the real prospect of not being able to meet their obligations in making interest payments on their treasuries, but that day is not foreseeable during the life of these treasuries, although a short term instrument like a treasury bill is still going to have a bit less risk of that happening with, practically none, compared to the risk of a 30 year treasury bond.

Beyond that, there are certain amounts of default risk present in bonds, which will influence the interest rate that they will offer. Corporate bonds are less reliable than government bonds generally, and will therefore offer higher rates as a rule, although this depends on the government, and some countries’ bonds can definitely be on the riskier side.

In buying bonds, private parties like individual investors can get into the banking business by lending money to governments and corporations and earn interest over time for doing so, without having to be in the banking business. Instead, the bond market provides all of the framework needed to make this all work.

Bonds are Publicly Traded Debt

What distinguishes bonds from privately financed borrowing such as banks provide is that bonds are completely securitized, meaning that they are offered as well as traded on the open market. When you look to get a loan from a bank, you may shop around at several banks, but as is the case with the private market, it is a closed market and will depend on the limited number of opportunities that are present.

While some privately sourced direct borrowing does become securitized, where banks and other large financial institutions buy and sell debt among themselves, they are still privately sourced. When bonds become issued though, they are issued in the public market and remain there until maturity.

Although bonds are publicly traded, meaning that anyone can buy and sell them who has access to the bond market, whether directly or through an intermediary such as a broker, bonds aren’t traded on exchanges like stocks and several other types of financial instruments are, and instead are traded over the counter.

Individual investors can still buy bonds through the dealers who have access to this over the counter network, which is essentially a network of dealers who trade the bonds between themselves. Buying bonds through dealers used to be the only way to invest in them, but with investment vehicles such as mutual funds and exchange traded funds on the scene now, we now see the overwhelming majority of individual investors participate in the bond market through the purchase of these funds.

Exchange traded funds do offer individuals the ability to trade bonds on an exchange, although fund based bond holdings are set up to be diversified generally and it’s not that people get to trade individual bonds directly.

One can also gain access to certain types of government bonds through contract for difference brokers, who handle these positions and buy and sell the actual treasuries as needed to manage the trades that are placed with them. Some contracts for difference brokers offer much better spreads than others, and with the better ones, one can gain access to these markets not only very easily but at fairly competitive pricing.

The other option available to individual investors is to trade bond futures, although futures trading tends to be beyond the acumen of most investors.

The Defining Characteristics of Bonds

Bonds, especially corporate bonds, can have a number of different features, and this can sometimes be confusing to individual investors, although individuals do not generally purchase corporate bonds individually that much unless one is a very large investor, and will likely have all the guidance they will need provided by those who are advising them.

Stripped down, there are really three main characteristics of bonds, which are the price, the interest rate, often called the coupon rate, and the maturity date.

Bonds are issued at a certain price, called the par value, and after they are issued, given that they are traded in the secondary market, their value will fluctuate, much like a stock’s price will.

Bonds are different from stocks though, due to stocks representing ownership in a company, with bonds representing a debt obligation to the bond holder, money borrowed which will be paid back over time with interest.

So it starts with the price, how much you will pay for a certain amount of debt, and the par value represents what the debt was when the bond was issued. The rate doesn’t fluctuate, it is either fixed or a floating rate based upon a spread with an interest rate benchmark, and the maturity date is fixed as well, so the only thing that can move with a bond is the price.

When you get a loan from a bank, the price does not move, and in this case it would be the principal amount borrowed. The rate and maturity date remain constant as well, aside from paying it off early and saving money on interest, and the interest rate or spread remains constant as well.

If the bank that you got a loan with were looking to sell your loan to another lender though, depending on how rates have changed since the loan was negotiated, the value of the loan would change. If for instance your rate on a $10,000 loan was fixed at 7%, and banks were now lending at 6% to those with the same credit worthiness, lenders would prefer to make the extra percent, and would be willing to pay more for this.

The same thing happens with bonds, although it is investors and not banks who are willing to pay more or less for the bonds depending on the difference between the interest rate of the bond versus what interest rates are now.

The price of bonds will then fluctuate both above and below a bond’s par value, the price it was issued at, depending on how interest rates have fluctuated, as well as normal supply and demand influences that all securities embody.

In particular, the demand for bonds by investors at any given point in time will have an effect on prices, and this is the biggest reason we can see fluctuations in bond prices even though interest rates haven’t changed. These fluctuations even occur on a second by second basis as demand fluctuates.

Bonds Therefore Offer Both the Potential for Capital Gains and Interest

While the value of bonds fluctuates based upon what the expectations are for interest rates in the future, these anticipated changes are already priced in at any given moment. Some people think that therefore everything is priced into bonds, and may think that this is the case with all securities, but what isn’t priced in is these fluctuations in supply and demand.

One may therefore speculate on bonds, buying and selling them based upon how they may perceive the price to change, on a purely technical basis, without even accounting for fundamental considerations such as interest rates that may influence the price of the securities.

Others may intend to hold the bonds long term, not being particularly concerned about the price that they are traded at, which only really matters if you are looking to trade, in other words, the intention to liquidate your position at some point prior to maturity.

Having bonds publicly traded, and having investors and institutions trade them regularly, does add a lot of liquidity to the bond market. This is the only real way that individuals can participate, as bonds are issued initially to large financial institutions, and individuals don’t even have access to this.

If one intends to employ any strategy with their bond holdings, in other words if they ever intend to entertain thoughts of selling them at any point, then pricing will matter. Capital gains or capital losses will occur depending on the price paid and the price received, in addition to taking into account the interest earned over the period that the bonds are held.

Some bonds do not even pay interest, called zero coupon bonds, where the entire gain is realized through capital gains. There are certain tax advantages that are available with this type of bond, as there is with certain government issued bonds which may be tax exempt as an incentive for people to invest in them.

Bonds therefore offer access to a wide variety of investment and trading strategies, anything from holding either long or short positions with bonds for just a few minutes, or even seconds, to holding bonds long term as a source of income.

Bonds also tend to be less volatile and more stable than stocks, although the price of bonds only really matter if you are looking to sell them, and if not, people can just sit back and collect the interest on them without even worrying about such things.

It is therefore easy to see how bonds are so popular among those seeking to supplement their income through regular interest payments, although this is certainly not the only use for bonds by individuals. The bond market is quite a bit bigger than the stock market and continues to play a very big role in the financial world.