Understanding Bonds
A bond is a financial contract usually between two parties. These are financial securities and are classed as fixed income securities. The bond market is massive and can be applied to financial intermediaries, companies and FX markets. When buying a bond you are buying the other party’s debt so when you purchase a bond you are effectively acting as a bank and you are lending to the other party. You will receive interest on the bond which is known as a coupon rate. The coupon rate is usually fixed hence the name of the asset class ‘fixed income’. However, there are some bonds which give a coupon rate which is set either by the LIBOR rate (London Inter-Bank overnight rate) or EURIBOR (European Inter-Bank overnight rate). Bonds are traded over the counter (OTC).
Government bonds are known by different names. UK government bonds are known as gilts, a US bond is known as a treasury and a German bond is known as a bund. Bonds usually have a time frame. You can have a 3-month, 6-month, 1 year, 2 year, 5 year and 10 year bonds. Although the length of the bond depends on the type of bond and from which country the bond is from.
Fixed rate bonds are affected by interest rates. If interest rates rise then the value of the bond decreases. The decrease in the value of the bond will translate to a higher yield. If there is a cut in the interest rate then we see a rise in the market price for bonds. In addition if you have an inflation-indexed bond then it will suffer from inflation rate risk. However, these risks can be reduced by hedging and diversifying their portfolios.
There are other types of bonds which include high yield bonds, convertible bonds, inflation-indexed bonds etc. High yield bonds offer the highest coupon rate and are also known as junk bonds. A key example of the utilisation of this type of bond is in Greece debt markets. Greek bonds are classified as junk status. However, having a higher coupon rate means a higher risk and thus you could make a loss if the value of the bond is sold at a premium.
A callable bond is one which can be cancelled by the issuer. A putable bond allows the buyer of the bond to claim payment before the maturity of the bond from the issuer. These types of bonds are closely related to options. Hence, when buying/selling a callable or putable bond it is advisable to read up on options. These bonds apply to the American, European and Bermudan bonds. Just like in options, similar rules apply to these bonds.
