Bond TradingBond trading provides an alternative way of investing as compared to stocks. When an investor buys a share of stock, they are buying an ownership stake in the company. In contrast, when an investor buys a bond, they are lending the company money. While investing in stocks tends to lead to growth of capital, most people invest in bonds in order to get a fixed income. So, you're playing the role of a banker. In exchange for lending money, the company or government agency that you lend money to by purchasing the bond pays you interest semi-annually or annually. The reason bonds are issued is to raise very large sums of money. While a small business would go to a bank to get a loan for $50,000, a corporation or government entity will issue bonds to raise $10 million or $100 million. They basically spread things out by slicing up the loan into little $1,000 increments and take loans out from many parties. These $1,000 loans are the bonds. The bondholders are paid interest on their loan, which is why many people invest in bonds to get fixed income.
Par Value or Face Value and Secondary MarketsWhen a bond is issued it has a par value or face value printed on the bond. This is usually $1,000, but other values are common. This is the price you will pay when purchasing a new issue. However, bonds trade on secondary markets, and prices fluctuate in bond trading. Two major factors affect the price. The first one is the prevailing interest rates. Prices of bonds move opposite to that of interest rates. If interest rates go up, bond prices go down. If interest rates drop, bond prices go up. The reason for these fluctuations are simple. Suppose that a company called American Imports issues new bonds at 4%. A year later, if conditions are such that interest rates are 6%, and American Imports issues new bonds at the higher interest rates, the older ones aren't going to be worth as much. Why would someone want to buy an old issue paying 4% when they can buy a new issue for the same price (remember they are issued in $1,000 increments) that pays 6%? So, to sell your 4% issue on the secondary market, you're going to have to drop the price and sell it at a discount. In contrast, if instead interest rates dropped to 2%, so that new issues which cost $1,000 paid 2% interest, your older issue which pays 4% interest is going to look great to investors. They will be willing to pay a premium, or mark-up above the face value for your bond. It could sell for say $1,200. Besides interest rates, prices of bonds may be influenced by the credit rating of the issuer. Agencies such as Standard & Poors, Moody, and Fitch provide credit ratings for corporations and government agencies that issue bonds. After all this is about lending money, so its important to know the credit history of who you're lending money to. If a corporation or government agency has defaulted in the past, which could mean either failing to pay back principal or failing to make an interest payment, they will have to pay higher interest rates. Bonds offered by such entities are called "high yield". A bad credit rating could influence bond trading, because investors may not be as interested in buying a loan made to a company with a poor credit history.
Yield vs. Coupon RateA bond is a loan. As such interest is paid on the loan. The interest rate is often referred to as the coupon rate. This is because historically, coupons were given to investors. At the appropriate date, they could be torn off and exchanged for interest payments. So the coupon rate is simply the interest rate on the loan you've made. In addition, the coupon rate, which is based on the face or par value, determines a fixed sum of money that is paid as interest. Bond trading involves buying and selling bonds on secondary markets. While many investors invest in bonds in order to receive fixed income, traders may be hoping to make money on the secondary markets from fluctuating prices that differ from the face value. When traded on secondary markets, prices may fluctuate above or below face value. An investor that buys on the secondary market is less interested in the coupon rate than they are in the yield. This is the actual percentage paid on the price used to buy the bond on the secondary market. So, if a $1,000 bond pays 5% interest or has a coupon rate of 5%, it pays $50 per year. Now if the bond is sold on the secondary market for $1,000, the yield is $50/$1,100 * 100 = 4.54 %. So the yield of a bond sold at a premium will be lower than the coupon rate. On the other hand if it were sold for a discount at $800, the yield would be $50/$800*100 = 6.25%. When purchased at a discount, yield is higher than coupon rate.
Some General Types of BondsThere are many different types of bonds. Bond trading covers not only lending to corporations, but also to city and county governments and even national governments. Municipal bonds are issued by city or county governments. Treasury bonds and savings bonds are issued by the US government. International governments also issue bonds. Securities issued by the US government are considered secure, because the US government has never defaulted on an interest payment or payment of principal. After all, all they have to do is print more money if they need it. Investment grade bonds are bonds from corporations or municipalities with good credit ratings. They are considered safe investments, but not as safe as US Treasury's. Municipal bonds can be "general obligation", which means they are backed by the taxing power of the issuing city, or "revenue" which means they are dependent on a specific stream of revenue the municipality receives (like a lease payment). Revenue bonds are more risky since the income stream could dry up. High yield or junk bonds are from corporations or municipalities with spotty credit histories. Bond traders are often interested in junk bonds.
Other Things To Be Aware OfThe date when your principal is to be returned is called the maturity. Some bonds can be called, which means the issuer can require you to return the bond and receive your principal back at an earlier date. The duration can give you an idea of how long such callable bonds are actually out on average. If a bond is callable there will be a date before which the bond cannot be called. Another option when bond trading are zero coupon bonds. Zero coupon bonds don't pay active interest payments. Instead they are sold at a discount to face value, and when you redeem them to receive your principal, you receive cash payment of the face value. In other words, a zero coupon issue of $1,000 would actually be purchased for say $950. When you redeem it later, you would receive $1,000 in cash. The $50 difference plays the role of your interest payment, but rather than receiving it semi-annually or annually, you only get paid when your principal is returned.
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