What Are Bonds

Ever since England issued the first government bonds in the 18th Century, these financial assets have become the instrument of choice for funds and investors wishing to maintain the value of their savings. Find out what bonds are and how to trade them.

Bond! Debt Bond!

Ever since England issued the first government bonds in the 18th Century, these financial assets have become the instrument of choice for funds and investors wishing to maintain the value of their savings.

The source of the word is the Nordic ‘bonda’, for peasant – one who is in bondage to the landowner who loans him/her the land he/she cultivates. And bonds, like shares, are issued in a stock exchange’s primary market, then traded over-the-counter or in a secondary market until it matures.

The British used them to raise funds for their war against France; Roosevelt preferred them to raising taxes for funding World War Two military expenses – such notables as James Cagney and Bugs Bunny advertising them to the public; and since government bonds are backed by a country’s treasury, they are considered ‘safe’.

But companies can issue bonds, as well. Unlike shares, a bondholder does not own part of the company, and the company is under no obligation to issue bondholders reports. In fact, a bond is more like a loan – the issuer receives funds, in return for which he/she pays a regular coupon – like an interest payment – and must, when the bond reaches maturity, return the face value – the original loan or principal – to the bondholder.

Rating the Issuer

Whereas shares are valued based on a company’s fundamental data, bonds are valued based on the issuer’s credit rating – his/her ability to repay the face value of the bond. This credit rating is determined by agencies, such as Moody’s, Fitch, S&P and others – each company approved and regulated by government agencies, such as the SEC in the US.

The circularity of the situation is immediately apparent when the government’s (albeit ‘independent’) Securities & Exchange Commission oversees a company that rates the creditworthiness of that said government. Moreover, until the early 1970s, major credit rating companies were paid for their work by the investors seeking impartial information; now, they are paid by the bond issuing agencies. Many consider the 2007 sub-prime mortgage fiasco to be a direct result of ratings agencies issuing false evaluations of mortgage-based securities and collateralised debt obligations – loans, many of which were unredeemable, bundled together and sold to investors.

Rating the Bond

Evaluating a bond’s value to maturity is relatively straightforward: to its face value (the principal issued by the bond issuer to the bondholder) add the value of all future coupon payments (interest). Its immediate market price, on the other hand, is this plus the credit quality of the issuer. This is determined by one of the aforementioned credit agencies, usually letter-bound (A, AA, CCC, etc.).

Unfortunately, there is no clear-cut formula for applying to the original formula, since the rating influences market sentiment. Subsequently, a bond issued by a low-rated issuer will offer a higher interest rate to countermeasure this. From here on, it’s simply a question of supply and demand. Additionally, yield spreads also widen as ratings fall.

In addition, one must take into account the central bank’s interest rate as compared to the bond’s coupon, since an investor has a choice to invest at the fixed rate of the coupon or take his/her chances with fluctuating interest rates. This too affects a bond’s immediately perceived value. When interest rates decline, so do coupon rates on bonds, since the demand for those bonds increases. Thus, if an investor buys a government bond with a 2% interest rate the day before the central bank raises interest rates to 3%, he/she is at a loss to the tune of 1%. The investor will then seek to sell the bond in secondary markets at a discount (as opposed to “at a premium”, which is above its current value).

Bonds as a Market Indicator

Since, as mentioned, the yield offered on a bond is an indication of the issuer’s stability, investors tend to examine the yield being offered at a government bond auction as a marker for that country’s economic situation. Thus, if we examine the US government’s planned bond auctions for December 2019 – January 2020, we see that, generally, the longer-term auctions offer higher interest rates:

4-Week Bill Auction         1.51%

3-Month Bill Auction       1.54%

6-Month Bill Auction       1.55%

2-Year Note Auction        1.601%

3-Year Note Auction        1.632%

7-Year Note Auction        1.719%

10-Year Note Auction     1.842 %

At the time of writing, the US Federal Reserve’s interest rate was 1.75%, and – at least until 2029 – the US treasury believes that it can offer its bills (T-Bills, Treasury Bills, are the popular nomenclature for US government bonds – loans by the public to the US government) at a lower rate than that offered by institutions that determine their interest rates based on the Federal Reserve’s base rate – the rate at which it loans money to secondary financial institutions. Until that date, investors will be receiving interest rates that are considerably less than those offered by banks that seek to profit on their loans from the Federal Reserve. Only on its 10-year note has it raised interest significantly above the FED’s present rate, assuming that by then the FED’s rate will have risen above.

Pros & Cons of Bonds

As we can see from the above, interest rates on new bonds will rise in tandem with interest rates as determined by the central bank, in order to stay competitive. However, central bank rates inversely impact the value of a bond, since higher interest rates mean lost money on a bond already bought at a previously lower rate. The rule of thumb is that for every per cent increase in central bank interest rates, the value of a bond declines by its coupon rate. Thus, if interest rates increase from 2 to 3%, a bond with a coupon rate of 1.5% will decrease in its immediate value by 1.5%; if rates rise by 2%, that bond will have lost 3% of its value, and so on.

In conclusion, bonds can lose their value, based on the whims of the central bank, and they can lose their value immediately if the issuer defaults on his/her loans. On the other hand, the latter, at least, is relatively rare, and the security of a fixed income plus the promise of the maturing windfall make them a favourite for – especially – retirement funds. When it comes to corporate bonds, they are certainly less volatile, although they perform less well – especially in the long term. And in many places, some bonds – particularly municipal bonds in the US – are exempt from federal, state and local income tax for local residents. Unfortunately, especially during a recession, it has been known for a municipality to go bankrupt.

Trading Bond CFDs

Bond CFDs usually track bond-based futures contracts, which are in turn traded at the Chicago Board of Trade or the Chicago Mercantile Exchange and regulated by the Commodity Futures Trading Commission. These are futures that require the holder to buy or sell a particular bond at a future date and at a predetermined price. The value of the contract equals the full value of the bond multiplied by a conversion factor, plus the accrued interest (which has already been paid).

Many brokers offer bond futures CFDs. However, before trading on a bond CFD, however, consult the economic calendar to see the yield being offered at an upcoming bond auction compared to the yield for the same length bond at previous auctions since this has a direct bearing on the value of the futures contract.