Introduction:

This article is all about bonds and in general the fixed income markets. To start with, a bond is effectively an IOU from one person to another. There is a legal obligation from the issuer to repay the investor. If this is not fulfilled the issuer default on his debts.

Components:

There are many components in bonds that you should be familiar with, even when it comes to trading Forex. Firstly;

  • Principal : Also commonly known as the Par value is the value that the issuer will have to pay back to the lender upon maturity. This ranges from $1,000 to $100,000 depending on the type of bond. This is also commonly the same value that the investor lends to the country or corporation.
  • Price : This aspect changes just as the price of a stock would, upon issuance price is normally  100. Throughout the life of the bond this price may vary due to demand for the bond. Any price above 100 is seen to be trading at a premium and anything below is at a discount. Normally it is quoted as the "clean" price, or the price without any interest that has accrued. If there is a $10,000 bond and the price falls from 100 to 90, it costs you $9,000 to buy an IOU for $10,000. This means that if you hold it until maturity, not only will you make $1,000 but also the interest on it.
  • Coupon : This is the rate of interest paid on the bond per year, it will be as a % of the principal for example 3% coupon on a $10,000 bonds pays out $300 per year. This is normally paid out twice a year but can be quarterly or even annually.
  • Maturity : This is the length of time that the bond has before the principal will be repaid. This can range from 90 days to 100 years.
Yield:

The current yield changes over the course of the bond where as the coupon stays central (unless is is variable rate fixed to Treasury bills or LIBOR rates).

Calculating the yield of a bond is very simple however it will rarely needed to be done as nearly every time you see a bond it gives you the current yield.

For example Company XYZ is issuing a bond with 7.5% coupon rate and has a face value of $10,000 and a Price of 100. Here it is quite easy to tell the yield is 7.5%. 

However using the formula - Yield = Annual payment / price

We can see that if the price falls to 90 then the yield will be  = 750 / 9000 = 8.33% or a 80bps rise.

Conversly if the price of the bond rises throughout its lifetime to say 110, the new yield will be 750 / 11000 = 6.82% which is lower than previous.

Typically you would see bonds listed as so:

*Courtesy of Bloomberg




Types of bonds:

There are many types of bonds that are traded and bought every day but the common ones are:

Government bonds : Like Treasury bills, they are issued by a country to fund its operation

Municipal bonds : issued by states of cities to run them

Corporate bonds : Issued by large companies as a form of financing to allow for growth.

Within these there are different styles that the bonds can take:

Fixed rate : this is when the coupon stays the same during the life of the bond, this is the most common type issued.

Floating rate : much like variable rate mortgages, these are pegged to a central rate, maybe central bank interest rates or government bonds.

Zero Coupon : much like the name suggests, there is no interest but it is offered at a large discount so you may buy for 90 and it will be repaid at 100.


Classification of Bonds:

Rating agencies such as Moody's, Fitch and S&P grade each bond that is available into different categories depending on how they feel the ability to repay the bond is. For example the UK, Germany and Switzerland are seen as very safe places to lend money to a so are given the highest rating -AAA- as the rating agencies believe it is almost guaranteed that your money will be repaid. 

*S&P and Wiki


Obviously will lower risk, lower reward is seen. So these countries can borrow for 10 years at a cost of under 1.5%. 

Some however with lower credit ratings such as Spain's BBB+ will yield nearly 7%. 

Application of Bonds in other markets:

Bonds are closely monitored by all traders and are a great indicator of fear and risk in the market. Many countries with extremely low interest rates that have been fixed for many years mean that when investors are looking for yield differential's they will look away from base rates and instead focus their attention government yields.

For example as shown in my previous article here. It shows how when the US 10 yr yield rose that the USDJPY exchange rate also rose, mainly due to the increase in yield spread.

Another use of bonds is the use of divergences from highly correlated assets. For example the SP500 is highly correlated to 10 Yr yield and so if they diverge you know that a correction in one or the other is to be expected.

*chart from Bloomberg


Spreads between different nations bonds can be a useful leading indicator of risk, in the past few weeks spanish - German 10 year spread has risen a lot to well over 5% and this is meaning risk is decreasing within in the markets and so EURUSD falls.


*chart from Bloomberg


Overall there is no specific ways to trade other markets with bonds, but it is very useful to gauge risk and how the markets perceive different nations.

Anyway, thanks for reading and I hoped you found this helpful.

Adrian.



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