What is Bond Trading?
Bonds are securities traded much like shares of stock in corporations and can be bought and sold through brokers or bond dealers. Unlike stocks, which give the investor a share in ownership, bonds are debts. Investors who are looking for income more than equity growth find bonds attractive.
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Types
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Bonds are essentially IOUs. Governments and businesses issue bonds to borrow money which must be repaid when the bond matures. Thee are three broad categories of bonds. Government bonds are issued by the US Treasury (and by foreign governments) usually in large denominations. Treasury bonds have par or "face" values of $10,000 or more. Municipal bonds are issued by state and local governments for special purposes or as general-purpose bonds and come in denominations of as small as $100. These bonds are often tax-exempt. Corporate bonds are issued (most often with par values of $1000) by for-profit corporations.
Function
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Bond trading increases the liquidity of bonds (how easily they can be converted to cash) by providing a ready market where investors can buy and sell them. Bonds, particularly those with high ratings, are a low-risk investment that provides a good return for people interested primarily in income rather than equity growth.
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Features
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Bonds are issued in varying denominations called the face value. This is the amount the borrower must pay the owner of the bond when it matures (usually from one to thirty years). Each bond has a coupon rate. This is a fixed sum paid each year, most often on a semi-annual basis. The bond price is rarely the same as the face value and as the bond is traded. Bond traders focus mainly on the yield. This is the effective interest rate on a bond and is calculated by dividing the coupon rate by the price actually paid for the bond (there is a link under Resources to a free online yield calculator). If a bond's price falls below the face value ("selling at a discount") the interest rate rises. Conversely, a bond whose price is above the face value ("at a premium") has a lower interest rate.
Considerations
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The key to understanding bond trading is knowing what factors influence the yield, since this is the main criterion determining bond prices. If prevailing interest rates rise due to inflation or changes in monetary policy, bond prices tend to fall, resulting in higher yields. If interest rates drop, bond prices rise, lowering the yield. Thee are other factors to consider. Long term bonds have higher yields because there is more uncertainty about what conditions will be like a decade than in a year or two. As bonds approach maturity the price will converge on the face vale. A very important factor is the bond's risk. Bonds are evaluated by ratings services such as Moody's (see link below). A bond with a high rating is considered safer and will usually have a lower yield.
Benefits
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For the investor, bond trading is an attractive option if the objective income. Bonds, particularly those with high ratings are very safe and provide higher returns than bank CDs, savings accounts. They can be included in IRAs and are excellent retirement investments. Government bonds such as US Treasury bonds, are the safest, but have lower yields. An option for people in high tax brackets are tax-free municipal bonds. Because they are exempt from taxes the yields are usually lower, but if a person is in a high tax bracket they come out ahead by investing in municipal bonds.
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