Essential Guide to Different Types of Bonds
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Bonds are a fixed-income product that provide a way of raising long-term funds for various bodies and institutions. Though there are different types of bond which we will discuss in this article, however 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 the 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 in further detail 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 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:
- Principal – the amount of debt that the issuer has taken on, and which they pay interest on to the bondholder
- Maturity – the maturity date defines when the principal has to be repaid to the bondholder
- Coupon – the interest rate paid by the issuer to the bondholder
- Yield – gauges the rate of return an investor would receive from a bond. This can be calculated in more than one way, but most simply it is the annual interest amount divided by the prevailing market price of the bond
- Current market price – bonds will vary in price over the course of their term as they trade on the secondary market
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).
Common Types of Bond
In this section, we are going to discuss four different types of bond. These are:
- Corporate bonds
- Government bonds
- Municipal bonds
- Supranational bonds
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 through 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 refer to corporate debt with a term of at least a year. Short-term debt is, instead, referred to as 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 in contrast 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 that they are an easy type of bond for individuals to trade.
Here is a list of some major government bonds:
- US T-bonds (also known as the long bond; they have long maturities, ranging from 20 to 30 years)
- US T-notes (medium-term US debt, with maturities ranging from 2 to 10 years)
- UK Gilts (there are medium - and long-term versions of the gilt, and both are UK government debts)
- German bund (long-term German debt with terms between 8.5 to 10.5 years)
- German schatz (also known as the short bund, it is a German debt with maturities of around 2 years)
- German BOBL (Bundesobligationen, a medium-term German debt, with terms between 4.5 to 5.5 years)
- Italian government bonds (also known as BTP or Buoni del Tesoro Poliannuali, are medium - to long-term Italian treasury bonds with maturities ranging from 3 years up to 30 years).
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 IMF and World Bank in 2016), yet it defaulted on its domestic debt in the late 1990s, and declared a debt moratorium on its foreign debt (meaning that it 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 around several trillion US dollars. In the US, the interest accrued on such debt is usually exempt from Federal tax, and sometimes may also be exempt from state tax.
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, and are also commonly referred to 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.
Trading with Bonds
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. Admiral Markets offers CFDs on bond futures and 10-year T-note futures, so that you have the convenience of trading bond futures as well as through MetaTrader 4 and MetaTrader 5. Just like FX (Forex) prices, the bond market can be moved substantially by economic news. If you are trying 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. The image below displays a screenshot still of our economic calendar which is part of MT4SE's Mini Terminal feature:
Source: MetaTrader 4 Supreme Edition (MT4SE) platform - Accessed: 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 within a risk-free environment. Our Demo Trading Account allows you to trade with virtual funds on products such as, FX currency pairs, CFDs on commodities, stocks, ETFs, and much more. There is zero risk involved, and you can use it as much as you like, until you are confident enough in your trading strategy, and ready to transition to a live trading account. We sincerely hope that you found this introductory discussion of the different types of bonds to be of some use. You might also want to have a look at our article on The Russian Financial Crisis to learn more.
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.