Bonds are not a very popular financial instrument among individual investors. They are often equated with safe investments, and therefore not very profitable. Stock market traders tend not to think about bonds in terms of instruments for speculation, and in certain periods of the business cycle the bond prices are growing the fastest when other markets are still in a bear market. So let’s look more closely at the bond market.
Bond is a debt security, thanks to which the issuer borrows capital from the buyer (bondholder) and is obliged to return this capital and accrued interest. In other words, the issuer sells the bond is a short position, and the bondholder is a long position.
A company wants to borrow capital for development, could issue bonds, and people with excess capital lend to the company for investment. Issuers of bonds pay interest on borrowed capital to buyers of bonds.
Bonds and shares are instruments of the capital market. However, bonds, unlike shares, do not give the holder such privileges as the right to property or the right to profit of the company, i.e. dividends. The bond holder has the right to receive a capital together with interest.
The companies finance their activities with their equity capital and foreign capital. Companies usually are not able to finance all projects only from equity, so they acquire foreign capital. Bonds are a very popular instrument for acquiring foreign capital in the United States, where the market is highly developed. On the other hand, bank loans are more popular in Europe. Usually raising capital by issuing bonds is cheaper than obtaining it in the form of bank loans, although not always. Certainly, the issue of bonds is more troublesome than getting a bank loan. Therefore, the issuing of bonds is usually decided by larger companies in need of acquiring large capital, and smaller companies or smaller needs are implemented through bank loans, although this is a certain generalization.
The bonds can be characterized according to several criteria:
- the nominal value which is refundable when the bond expires and from which interest is paid,
- maturity date, which is the period of returning the borrowed capital, i.e. the face value,
- interest rate (profitability, coupon), i.e. the amount of interest paid to the bond buyer, expressed in a year,
- Interest payment dates, i.e. periods of interest payment, are usually paid once a year, once every six months or once a quarter.
Types of bonds
The capital market offers many types of bonds. They can be divided according to two main criteria, the interest rate and the issuer.
According to the interest rate criterion, we distinguish:
- fixed-rate bonds have fixed and known interest rates, which allows you to specify all payments due to their ownership in advance,
- floating rate bonds have interest that depends on a certain reference rate. The reference rate is usually interest rate on loans on the interbank market, e.g. WIBOR, LIBOR, EURRIBOR,
- zero-coupon bonds do not pay interest. The bondholder buys such a bond cheaper than the nominal value, i.e. at a discount, and when the bond expires, it receives a nominal value.
According to the issuer’s criterion, we distinguish:
- government (treasury) bonds,
- municipal bonds,
- corporate bonds,
- bank bonds (less frequent).
The above bonds differ mainly with the risk incurred and usually with profitability. The most secure from the buyer’s point of view are government bonds and are usually lower interest than the rest. In turn, corporate bonds are the least secure and their profitability is usually the highest. The company is much easier to get into financial trouble and even go bankrupt than the state.
Due to the fact that interest is usually charged on bond and that it can be purchased on the secondary market, we distinguish four types of prices:
- the nominal value, as already mentioned, is the amount that the issuer wants to obtain and interest is accrued on that value,
- the issue price, i.e. the price of bonds sold on the primary market. The bonds may be sold at a price equal to the nominal value, at a price higher than the nominal value (with a premium) or at a lower price than the nominal value (at a discount),
- the market price (bond price), which is sometimes called the “pure price”, does not include accrued interest. The bond rate is given as a percentage, for example 98.5%, which at a nominal value of PLN 1,000 will mean that the market price is PLN 985. The pure price is used in stock quotes,
- the settlement price sometimes called the “dirty price” includes accrued interest. It consists of the bond price multiplied by the nominal value and accrued interest. This price indicates how much the investor must pay for the bond de facto. For example, the nominal value of bonds is PLN 1,000, the rate is 98.5%, and the annual coupon is 5% per annum. After three quarters, the dirty price will be 1000 * (98.5% + 280/365 * 5%) = 1000 * (98.5 + 3.84) = 1000 * 102.34 points. percent. = PLN 1033.4.
Bond price and profitability
The bond yield is in other words its interest, which the buyer’s issuer must pay for borrowed capital. The yield on bonds with a longer maturity is usually higher than on bonds with a shorter maturity. However, there are moments when this rule is broken, which may indicate the upcoming problems in the economy, and the same stronger drops in the stock markets. In addition to the duration of the bonds, the entity that issues these bonds also affects the profitability. Treasury bonds are considered the most safe, although not all of them, of course, include Greek bonds.
The average investor is mainly interested in the amount of the coupon and the solvency of the issuer, as it will probably hold its bonds until they are bought back and the nominal value returned.
However, the prices of bonds can also be boldly speculated on the secondary market. The speculator will pay more attention to the market price of the bonds, hoping for a change, which will allow him to earn. Here we come to a very important relationship between profitability and price.
Profitability is inversely correlated to the price of bonds, i.e. a decrease in profitability will result in an increase in the price of bonds and vice versa. For a better understanding, let’s take a simple example. The American bond costs USD 100 and its coupon is 2%. After some time, the interest rate increases to 3%, due to a number of factors, such as higher inflation forecasts or a more restrictive policy of central banks. The increase in profitability will cause that bonds from the new issue will enjoy greater interest, and the price of old bonds will start to fall, as speculators will dispose of them for the benefit of new ones. A fall in the prices of old bonds will result in an automatic increase in its profitability, which results directly from the formula for the price of bonds. This is the scenario for traders who play shortly and vice versa.
Bonds for litmus paper for the stock market
The bond market usually overtakes the stock market in its operations – alternatively changes take place simultaneously on both markets – which is an extremely valuable tip for speculators involved in the stock market. The collapse of government bond prices in the long-term uptrend may be a signal that it is time to think about closing long positions on the stock market. The debt market is strongly influenced by changes in inflation interest rates and usually responds earlier to their changes or expectations to change them than the stock market. In turn, after the recession, the debt market will usually start growing earlier than the stock market. After a period of turbulence in the economy and on the financial markets, central banks will react by reducing interest rates, and this will increase bond prices, after which capital will be transferred to the more risky stock market. The bond market most often overtakes the stock market by a few to several months.
Another important element warning against the upcoming market crash may be a reverse yield curve. Under normal market conditions, bonds with a longer maturity, e.g. 10 years, will have a higher interest rate on bonds with a shorter deadline, for example 2 years. There are periods when this relationship is reversed and bonds with a longer maturity have a lower interest rate than those with a shorter maturity. This phenomenon is called an inverted yield curve. This is obviously an abnormal situation and a very big warning against possible major turbulence in the economy, and thus on the stock exchanges. This situation can be explained by the fact that investors are so insecure about the near future that they are punished to pay more for borrowed capital borrowed for a short period.
Summing up, the bonds give many tips on the stock market. Bond prices will sooner react to changes in interest rates, so after the meltdown, the debt market will start to grow earlier, which will be a sign that the stock market may rise after some time, this period lasts from a few to several months and vice versa. The collapse in the bond market gives early signals that the stock market may also break down. In addition, when there is a reverse yield curve, we should stick to attention because it can mean serious economic problems and a breakdown in the markets.