Bonds are a fixed-income product that provide a way of raising long-term funds for various bodies and institutions. Though there are various types of bond, which we will discuss in this article, all bonds work in the same basic way, fundamentally.
Bonds are a type of debt. In other words, they are effectively an IOU ( I Owe You, which is effectively a pay promise made by the bond issuer to the bond holder as per terms of the Bond Instrument). The bond issuer takes on the debt and the person that buys the debt, the bondholder, is the one providing funds. The bond issuer can then use those funds to finance whatever spending plan they wish. In return, they pay a fixed interest on the debt at regular intervals for the life of the bond. At the end of the term of the debt, the bond is said to mature, at which point the issuer repays the original sum of the debt (known as the principal).
The transaction where new debt is issued to buyers is known as the primary market, but this only comprises a part of the whole bond market. The bond market also has a secondary market, in which the bonds issued previously are traded between buyers and sellers as debt securities. The bond market is vast, far exceeding the stock market in terms of value.
The largest issuers of debt are governments. Governments issue long-term government bonds in order to help finance expenditures needed to support their countries. Other major issuers of fixed income debt include banks and corporations. We will discuss both government bonds and corporate bonds below.
Bonds are not the only type of debt security, of course. Other types include debentures, notes, and commercial paper. Generally speaking, bonds tend to have longer terms than these other debt securities.
Before we look at some common types of bond, let's first quickly summarise some key terms that we use when talking about bonds:
There is an intimate relationship between interest rates and bond. As bonds pay out a fixed sum periodically, they become more attractive when interest rates fall and less attractive when rates rise. Bond market prices may therefore vary from the issue price and are often used as a proxy for medium- to long-term interest rate expectations. Naturally, the price of a certain of type of bond will also be affected if perceptions change regarding the creditworthiness of the issuer (see also the section on bond ratings below).
In this section, we are going to discuss four different types of bond. These are:
Companies can raise funds through two main avenues: floating shares or by issuing debt in the form of corporate bonds. There are many reasons that a corporation may wish to raise money by such means, including mergers and acquisitions activity, and funding the cost of expansion.
Raising capital comes with a cost, of course. In the case of shares, the company gives up a share of voting rights and, usually, a dividend. With debt, the company incurs interest costs. While a company may issue debt with a wide range of maturities, corporate bonds usually refers to corporate debt with a term of at least a year. Short-term debt is instead called corporate paper.
The secondary market in corporate bonds is most commonly transacted over-the-counter (OTC), though some corporate bonds are exchange-traded.
Government bonds are a type of sovereign debt. Government bonds typically have maturities of medium or long time-frames, anywhere from a couple of years up to several decades. This is as opposed to forms of short-term sovereign debt, such as treasury bills (T-bills).
Major government bonds have very liquid exchange-traded futures contracts available, meaning they are an easy type of bond for individuals to trade.
Here is a list of some major government bonds:
Though the liquidity and risk is dependent on the government in question, as a general rule, government bonds tend to be liquid and are perceived as low-risk, particularly for countries with large, established economies, such as the G7 nations.
It's worth noting, though, that there is always some risk attached. For example, Russia has the twelfth largest economy in the world (as measured by the IMFand World Bank in 2016), yet defaulted on its domestic debt in the late 1990s and declared a debt moratorium on its foreign debt (that is, delayed meeting its financial obligations) when it found itself in economic strife.
Municipal bonds are are a type of sub-sovereign bond. In the United States, the bonds issued by the Federal government are Treasury notes and bonds, as mentioned above. Below the Federal level, smaller branches of government also issue debt in order to fund their capital spending programmes. Debt securities issued by a local government entity or agency, such as states, cities, counties, and even schools and publicly-owned airports, are called municipal bonds or muni bonds. The municipal bond market is large, valued at several trillion dollar. In the US, the interest accrued on such debt is usually exempt from Federal tax and sometimes may be exempt from state tax also.
A supranational bond is a long-term form of debt that transcends the boundaries of a single country. These are very similar to government bonds, and tend to have a high credit rating. A good example of supranational bonds are those issued by the European Investment Bank, a long-term lending institution owned by the member states of the European Union (EU).
As we have established, a bondholder is effectively loaning out money to the bond issuer. Now, when it comes to lending money, one of the key things you need to know is how trustworthy the borrower is. This is where bond ratings come in. Companies such as Moody's and Standard & Poors provide credit ratings services that aim to help investors make a judgement on how likely a debt issuer is to fulfill its payment obligations.
The highest rating is AAA. Bonds that are rated BBB or higher are said to be of investment grade. Bonds that are rated BB or lower are designated as high yield, also commonly known as junk bond status. A bond that has a junk bond status is considered to be at greater risk of default. This depresses the attractiveness of the debt, all things being equal; consequently the issuer of the debt is forced to set the coupon at a higher rate in order to attract funds.
As mentioned earlier, when discussing the market price of bonds, the value of a bond is strongly tied to interest rates. This makes bond futures a good way to trade if you have a view on the future performance of interest rates or if you are looking to hedge your exposure to interest rate risk. We offer CFDs on bond futures and 10-year T-note futures, so that you have the convenience of trading bond futures as well as Forex (FX) through MT4.
Just like FX prices, the bond market can be moved substantially by economic news. If you are looking to stay on top of what is affecting the financial markets, it helps to have all the tools you need readily at hand as part of your trading platform. This is why you might like to try the free download of MetaTrader Supreme Edition. MT4SE is a plugin for MetaTrader that greatly expands the indicators and other trading tools in the platform.
Image source: MT4SE platform, 12 December 2017
Whichever product you are looking to trade, be it bonds, shares, or FX, a great way to start is by trying it out in a risk-free environment. Our Demo Trading Account allows you to trade with virtual funds, so that you have zero risk until you are confident in your trading strategy and ready to trade for real.
We sincerely hope you found this introductory discussion of the different types of bond to be of use. You might also want to have a look at our article on The Russian Financial Crisis.