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Bonds are debt instruments that are issued by companies, municipalities and governments to raise funds for financing their capital expenditure. By purchasing a bond, an investor loans money for a fixed period of time at a predetermined interest rate.While the interest is paid to the bond holder at regular intervals, the principal amount is repaid at a later date, known as the maturity date. While both bonds and stocks are securities, the principle difference between the two is that bond holders are lenders, while stockholders are the owners of the organization.
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Types of Bonds
The main types of bonds are:
- Government Bonds: These are fixed-income debt securities issued by the government. Government bonds are further categorized on the basis of the term (maturity duration). (a) Government Bills: These are government bonds with a maturity period of less than one year. (b) Government Notes: These are government bonds with a maturity period from one year to ten years. (c) Government Bonds: These are government bonds with a maturity period that exceeds ten years.
- Municipal Bonds: These are debt securities issued by state governments and their agencies. The interest is exempt from federal income tax or local tax.
- Corporate Bonds: These are debt instruments issued by a company and backed by its ability to generate profits or by the current value of its physical assets.
How Bonds Trade
Bond trading is usually done through bond dealers and can take place anywhere where a buyer and seller strike a deal. Unlike for equities, there is no exchange for bond trading, which mostly takes place in an ‘over-the-counter’ market. The exceptions for this are certain corporate bonds, particularly in the US, that are listed on an exchange. Moreover, derivatives, such as bond futures and certain bond options, are traded on exchanges.
Bond Price Variations
A bond’s price refers to the amount investors are willing to pay for an existing bond. The bond’s price is important if you wish to trade the bond with another investor. The main factors that impact bond prices are:
- Interest rate: When interest rates in the market rise, newly issued bonds become more lucrative (offer higher yields). This makes existing bonds less competitive and exerts pressure on the price of existing bonds. Thus interest rates and bond pricesmove in opposite directions.
- Inflation: High inflation erodes the value of the return that is earned when the bond matures. Thus inflation and bond prices also move in opposite directions.
- Financial health of the issuer: The financial health of the company or government that has issued the bond impacts bond prices. If the issuer is financially healthy, investors have greater confidence in receiving the interest payments and principal amount at maturity. Investors typically stay in touch with the ratings issued by reputed credit rating agencies, such as Moody’s and Standard & Poor’s.