The Basics of the Bond Market

The bond market is one of the most dynamic and powerful investment markets in the world. Billions of dollars go through the bond market every year and investors can not resist the possibilities that this market holds. If you are unfamiliar with the bond market and how it works, here are a few things to consider about it. 

Bond Basics

A bond is a debt instrument that can be purchased by an investor. Once a bond is purchased, the investor receives regular interest payments over the life of the bond. This form of investment is sought after by many because of its consistency and relative safety to other type of investments. When you buy a bond, you are actually a creditor. This puts you in a position to potentially get your investment back even if the issuing entity goes bankrupt. This safety attracts many investors that do not want to invest in the stock market because of the risk involved. 

Bond Trading

While you can buy bonds when they are initially issued by the company, most of the action in bonds takes place on the secondary market. This happens when someone has a bond and they resell it to another individual. You may be wondering why someone with a bond would want to sell it. 

There are actually a few reasons that someone with a bond might want to trade it. The first reason is because of the cash flow involved. Bonds are, by nature, a very long-term investment tool. When you own a bond, you are getting regular interest payments, but they take place over a long period of time. Sometimes, investors do not feel like waiting on the interest payments to come in. They want a lump sum of cash and they want it now. They can then sell the bond to someone else and take the cash. 

Another reason that you may want to sell a bond is to make a profit. You may be wondering how it is possible to make a profit on a bond. Here are the basics of how you can make a profit trading bonds.

Profiting From Bonds

Trading bonds has everything to do with how they are valued. Valuation of bonds is critical for traders and it makes a big difference financially. When a bond is issued, it has a "par value" or face value. It also has a "coupon rate" or interest rate that it pays throughout the life of the investment. 

Investors will look at a bond and the coupon rate in order to value it. They will compare the coupon rate to the current interest rate in the market and decide whether the bond is worth more or less than the par value. 

For example, let's say that you bought a $1000 bond with a coupon rate of 3.2%. If you were to hold it for a few years and then decide that you want to sell it. At that time, the interest rate is only 1.3% in the market. Therefore, your bond is worth more than $1000. If you sell the bond, you will make a profit beyond what you paid for it. This is the essence of trading in the bond market.

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