What are Bonds?




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After posting my first ever introductory stock market video and post last week, before continuing about other forms of stock market trading and investing I need to cover an introduction to bonds. Why? because when developing balanced investment portfolios or learning to capitalize on different market movements, bonds are a great way to do that. Bonds get a bad rep because of their perception, but I have actively been trading bonds for at least a full year and they are great to perform various investment hedging, speculation, and more.

What are Bonds?

Bonds are a type of debt called a “fixed income”, the reason for calling them a “fixed income” is because they return a fixed percentage no matter what for a certain period of time. Fixed incomes come in various shapes and sizes. A “Bill” is any fixed income that is less than 52 weeks (can be found as low as 4-week maturity), a “Note” is a fixed income with a 1-10 years maturity, and “Bond” is any fixed income with maturity above 10 years. What does maturity mean? With fixed incomes, you give your money to whoever is issuing the fixed income and in turn, you are given a fixed % yield for the set time frame and on the maturity date, your original investment is then paid back to you.

Who Issues Bonds/Fixed Incomes?

Bonds and other fixed incomes are issued by many different entities including the United States (Called Treasuries), Corporations (Corporates), and local/state governments (Municipals).

Why Do They Issue Them?

Fixed incomes are issued in order to raise money. This is the same concept that we discussed in our stocks post last week, the major difference is when issuing stock the company is giving up a piece of ownership while when issuing bonds no ownership is being given up (there are convertible bonds [bonds that the holder can convert into stock] but we won’t discuss that). Rather, the issuer is just obligated to pay the interest and repay the principal upon maturity. Some benefits of bonds over holding a companies stock is that you will get a guaranteed % return (unless the company defaults) and you will be paid off before stockholders in the instance of a bankruptcy (because you are a debtor to the company, companies must pay off their debtors before distributing money to owners).

There are many types of ratings to determine the quality of debt, these come in various measures like Moody’s scale of C, Ca, Caa, B, Ba, Baa, A, Aa, Aaa with Aaa being called “Triple A” meaning the highest rating of debts. When investing in these triple-A ratings, you are much more likely to get very low returns because its a safer investment. The safest investment is treasuries or government fixed incomes. These Treasuries are considered the safest investments in the world, thus creating returns much lower than the likes of a corporation, but still yielding higher than foreign governments.

Using Bonds To Invest

Thus far Bonds may seem like a very poor investment, you have to wait months or years to get your money back? That sounds unappealing, right? Well, that’s not the case, there are many many ways you can capitalize on certain market movements and be able to get in and out of a position within stock trading hours! ETFs and futures, when trading bond ETFs like “TLT” or “IEF” you can invest in certain maturity bonds (IEF is 7-10 years, and TLT is 20+) and capitalize on the movements of the BONDS and still get some of that fixed % income! Or you can trade likewise futures contracts, but that is more complex and has a much higher risk (due to the 100k face value of the future) so we will discuss that in a different post.

Trading bond ETFs may take some time to understand but, bond ETFs move the opposite of interest rates. What does this mean? If a 2-year treasury yield is at 2.50% and then falls to 2.25%, the underlying bond has RISEN. This is because the demand for that bond has risen (driven by purchasing of the bond) which causes the price of the bond to rise to mean that the original % yield is less. You can see an example below, the blue line is 10-year interest rates and the orange is the price of the 7-10 year bond ETF. As rates fall, the ETF rallies and vice versa.

US 10-Year Government Bond Interest Rate Chart

US 10-Year Government Bond Interest Rate data by YCharts

What Moves Them?

Just like any asset class, bonds move based off of a variety of market conditions. In a rising interest rate markets bond prices are falling, in a market where conditions are uncertain (recently) bond prices rally as a result of investors putting their money where they know they will get fixed returns, and more. When balancing portfolios with bonds or speculating on interest rates with bonds, it’s important to know how they are impacted and how they fit into the overall market, that is why I decided to do this post/video today rather than continue with stocks.

Conclusion

Bonds and Fixed incomes are investments with fixed returns, they are primarily used by older investors to capture fixed returns and used by companies to raise capital. But what most people don’t know is that they can also be used to speculate on market conditions and interest rates as the underlying bond itself actually does move, less than stocks, but it does move. For this reason, it is important to understand how markets can impact bonds and how to utilize bonds in various market conditions because they can be a prime addition to your portfolio or trading plan.

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