Trading Government Bonds
What are Bonds?
Governments and companies frequently need to raise finances in order to finance new investments and projects. Rather than taking a loan, they can issue bonds.
A bond is a debt investment where an investor loans money to a company or Government for a defined period of time at an agreed interest rate.
They are different from shares because they pay interest and do not provide a stake in the issuing organisation.
How do Bonds Work?
Investors lending to governments or companies can buy the bond and in return every year the bond will pay interest. This is often referred to as the coupon.
Bonds have a maturity date – this is the date when the government has to pay back the principal, the original amount it borrowed. Government bonds are issued with a range of maturity dates, from short term bonds to those which have a 30-year lifespan.
Bonds are debt securities which can be traded amongst investors. The market price of the bond will depend on a number of factors including the credit rating of the issuer, the length of time until maturity and the coupon rate compared to current interest rates. When someone sells a bond at a price lower than the face value, it’s said to be selling at a discount. If sold at a price higher than the face value, it’s selling at a premium.
Bond Trading Example
A 10 year bond is issued with a 6% coupon value. If interest rates were to rise to 7%, the 6% coupon value is below the current market rate not an attractive option for investors. The bond price will decrease and will sell at a discount.
If interest rates were to fall to 3, the bond will continue to pay at 6% and will be an attractive option for investors. The price of the Bond will increase and sold at a premium.
Where are Bonds Rraded?
Corporate and government bonds can be traded publicly on exchanges. They are often traded over-the-counter (OTC) – this means they are generally traded between dealers, acting on behalf of clients.
What Drives Bond Prices?
Demand for bonds on the part of long term investors, particularly institutions.
The supply of bonds – how many new bonds are coming onto the market?
Bond ratings, particularly if these are upgraded or downgraded
Interest rates being paid by banks.
The state of a country’s economy, including how much it is borrowing, and whether the market thinks it will be able to pay its debts.
Whether the equity market is seen as too risky – historically, the bond market was regarded as a safer place to invest. This has changed since countries like Greece are in danger of going bankrupt.
How long a bond has to go before it is redeemed (the principal is paid back). This will influence the price, as investors will know how much more they can expect in terms of interest payments.