How Are Bonds Traded?

After conducting research into bonds as an investment vehicle, many investors decide that these would meet their risk appetite level. The UK bond market can be attractive to investors with a large variety of bonds available, and having decided to invest the next question tends to be, “How are bonds traded in the UK?

 

Firstly, a very brief introduction to the bond market in the UK is merited.

Bonds issued by the UK government are known as gilts or gilt-edged securities, which are debt instruments where the government promises to pay the gilt holder interest throughout the life of the gilt and the full amount of the principal plus an interest payment on the maturity date. This maturity date can be anywhere between 1 and 50 years, and the principal amount, interest rate and maturity date are all shown on the instrument itself.

In addition, the bond market in the UK also comprises debt securities issued by other borrowers, such as public authorities, credit institutions, and companies.

 

When bonds are first issued by any of the above borrowers, they are issued in the primary market, which can either be by securities firms or banks, who form a syndicate to buy the bonds from the issuers and then sell them on to investors, or in the case of UK government bonds, by auction, which is run by the UK Debt Management Office.

So, if investors are looking to purchase bonds when they are first issued, the options available are to contact the book runnners arranging the bond issue or the DMO to arrange their investment.

 

However, many bondholders do not wish to hold on to the bonds in their investment portfolio until maturity, and decide to realise their investment by making the bond available for sale. This also tends to be the situation when new investors are trying to find out how bonds are traded.

The bonds made available for sale are then traded in the secondary markets, although these are very different from the secondary equity markets, as there are no centralised stock exchanges with physical locations for the purpose of trading bonds.

The reasons being that bonds have a wide variety of characteristics (i.e. different yields and maturities) so there are a significantly higher number of bonds in issue when compared with equities. There are over 150,000 bonds in issue because of the number of issuers and issues, making the bond market less concentrated.

In contrast, as stocks are only common or preferred classes, then the number of types of stock traded are relatively small, with around 6,500 shares being admitted to regulated trading markets across the European Union.

In addition, the factors that affect bond prices, such as credit ratings and interest rates, tend to be different from equities, which can be affected by daily announcements relating to the company’s markets and activities. As the factors that affect bond prices do not tend to change on a daily basis it is rare for there to be many buyers and sellers trading regularly enough to support liquidity in any bond, which means there is less need for a centralised exchange.

 

How are bonds traded in the secondary markets?

Bonds are traded in an over-the-counter market via a network of bond dealers and brokerage firms, who provide liquidity to the secondary bond market.

The brokers will take an order from a client for a particular bond investment and will then, in the capacity of intermediaries, aim to find a current investor who would be willing to sell at the specified terms. The broker will aim to negotiate a price that meets the requirements of both the buyer and seller and also lets them make a profit.

Also, these brokerage firms will sometimes put their own capital at risk by buying bonds from investors even if there is no buyer currently available. The premise is that they will be able to find a buyer in future and sell them the bonds at a profit.

 

The role of these bond dealers is crucial in trading bonds because they “make a market” for the securities in question, and provide the required liquidity to the market when it is required.

If an investor wishes to invest in bonds then they should open an account with a major brokerage firm for the express purpose of trading bonds that have been issued previously in the primary market. A certain amount will be required to open the account and there may be a requirement to hold a minimum ongoing balance, but as soon as the account is active it will be possible to start trading in bonds.

 

How To Calculate Bond Yields

The bond yield is the amount, expressed as a monetary figure but usually a percentage, that shows the return you receive on any bond. Calculating bond yields is actually a very simple process, although it can seem slightly confusing at first. A key aspect to bear in mind is that bond yields can fluctuate on a daily basis, as the price of the bond will change on a daily basis.

Before calculating bond yields, it’s worthwhile looking at the different types of bond yields that investors refer to. There are three key different types of bond yields, namely the coupon rate, the running yield and the redemption yield.

 

The Coupon Rate Yield

The coupon rate is the interest rate that the bond originally pays on issue and is the simplest to calculate. Usually, it is provided in the bond’s name. As an example, a 5% Treasury bond will pay a coupon of 5 per cent. If an investor had purchased it when it was originally issued, they would receive 5 percent every year for the remainder of the life of the bond. Another term for the coupon rate is the interest rate.

To calculate this bond yield you use the formula: coupon amount divided by the par value of the bond. If you purchase the bond at par, i.e. you purchase a £100 bond for £100, then the yield is the interest rate, so the 5% Treasury bond has a 5% coupon rate yield.

 

The Running Yield

However, bonds are purchased and sold in the secondary market, and as they are traded the bond prices fluctuate in value. When the price changes after issue, the yield is known as the running yield. This can also be referred to as the income yield, flat yield or current yield.

The running yield is calculated as the annual interest payment divided by the current bond price (excluding any accrued interest on the bond), and only refers to the bond yield at the current moment. It does not take account of total return over the investment life of the bond or of any re-investment risk that may arise.

Calculating the running yield is simple. Going back to our example of the Treasury 5%, let’s say that it has five years to maturity, has a nominal value of £100 and is currently being sold for £120. From its name, it is clear that is pays a coupon worth 5% of £100, so £5 per annum. So, the running bond yield is £5 / £120 = 4.16%.

 

The Redemption Yield

Finally, the redemption yield, which is also referred to as the yield to maturity or the YTM. Bonds with a fixed maturity date pay back the par value or nominal face value when they mature.

If an investor purchases a bond below the par value and then holds it to maturity, they will achieve a capital gain. If they purchase the bond above par value and hold it to maturity they will incur a capital loss when the bond matures. The redemption yield aims to take into account all factors that will affect the investment gain or loss achieved from holding a bond until maturity.

The redemption yield is the Internal Rate of Return that will be earned by an investor who buys the bond at today’s market price and holds it until maturity, receiving all coupon and principal payments until then.

For example, let’s say an investor purchases a bond for £95 that has one year left until maturity and pays a 5% coupon. After this one year, the investor receives £5 income and another £5 when the bond matures, giving a total return of £10. Dividing this 12 month return of £10 by the purchase price of £95 gives a 10.53% redemption yield on this bond.

As this calculation aims to give the full picture of any investment in bonds, it is the most accurate of the bond yields to use and lets investors compare bond investments that have different interest coupons and maturity dates.

 

The Different Types of Bonds Available

If you are considering investing in bonds it is important that you are fully aware of the different types of bonds available and their associated features. It is only once you understand the risks and the reward associated with any bond investment that you can make an informed decision.

 

There are a few types of bonds, but these all share a common characteristic, in that they represent the debt of the issuer. So, whether a government, local authority, company or other organisation issues the bond, they are debt instruments, or loan stock that in the majority of cases have a fixed date for repayment and pay interest during the life of the bond.

 

Bonds provide the issuer, or the borrower, with funds that can be used to finance long term investments, and in the case of government bonds, these are also used to finance the shortfall between revenues and current expenditure.

 

As bonds are generally less risky than equity investments (although not always), it tends to be institutional investors, such as banks, pension fund managers and insurance companies that invest in them. However, it is also possible for retail investors to invest in bonds.

 

A key difference between bonds and equities is that the bondholder does not own a stake in the organisation that issues the bond. The bondholder is a creditor of the company and ranks above the equity investors for repayment should the organisation get into financial difficulty.

 

Bonds can be split into Gilts or UK Government Bonds and Corporate Bonds, which cover the majority of bonds issued and traded in the market.

 

Gilts or UK Government bonds

Gilts are the name used for bonds that are issued by the UK government to finance the shortfall between tax revenues raised and public spending. There are different types of bonds currently in issue and these are all highly rated because of the UK government’s track record in paying its debts.

 

There are three types of bonds issued by the UK government, with the most common of these being termed Conventional Gilts, which guarantee payment of a fixed interest coupon to the bondholder twice a year and when the gilt matures, as well as full repayment of the nominal amount.

 

The second most common types of bonds issued by the UK government are Index-Linked Gilts, which differ from Conventional Gilts only in the way that the interest payments and principal amounts are calculated. These are referenced to the General Index of Retail Prices in the UK, which make these types of bonds a useful hedge against inflation.

 

The third type of UK gilts are Perpetual or Undated Gilts, where the bonds were issued with no set maturity date and can be paid back by the UK government when it wishes to do so. These have very low coupons so it is not really in the government’s interest to redeem them, as they offer cheap borrowing.

 

Corporate Bonds

Corporate bonds are also referred to as loan stock and these may be secured or unsecured. If a company wants to raise capital to fund a longer term investment requirement, and it is sufficiently creditworthy and attractive to investors, it can issue corporate bonds as a way of achieving this.

 

These corporate bonds may require to be backed by security over the company’s assets if the company has a lower credit rating to improve the likelihood of investors taking up the issue, as the investors, as creditors, can push for the sale of these assets to force a payment, in a worst case scenario.

 

In order of lowest to highest investment risk, the lowest risk corporate bonds are referred to as Investment Grade or High Grade bonds. These are the highest quality corporate bonds and this quality level is determined by an assessment that is conducted by ratings agencies, such as Standard & Poors or Moody’s.

 

Corporate bonds that are below investment grade are referred to as High Yield Bonds or Junk Bonds. The issuer of these types of bonds has a lower credit rating and there is a higher probability that they may default on repayment. To compensate investors for investing in these higher risk bonds they require a higher rate of interest, or higher yield, from the issuer.

 

There are other terms that may be used to describe bonds, although these tend to describe a characteristic of the bond and can be equally applied to different types of bonds. For example, fixed rate bonds pay a constant coupon throughout the bond’s life, or zero bonds, which don’t pay any regular interest at all, but are issued at a significant discount relative to their redemption value, so investors look for capital appreciation to compensate for the lack of interest payments.

 

Another example is convertible bonds, which include the ability for the bondholders to convert these into the company’s ordinary shares upon payment of a conversion premium.

 

Bond prices fluctuate but they are typically seen as a more conservative investment choice than equities. However, it is very important to understand the type and characteristics of any bond before investing in it.

 

What Is A Bond?

What is a bond?

 

A bond, or a government bond, is when a government borrows money by way of selling monetary instruments to investors. In other words, a bond is simply an IOU. In exchange for the cash from the investor, the government guarantees that it is going to pay an agreed rate of interest over a certain period of time.

 

For example, it could be 4 percent each year for 10 years, and after this time period has elapsed, in addition to receiving the interest payments during the life of the bond, the investor is paid back the cash they initially invested by the government. This has the effect of cancelling that specific part of government debt.

 

How about in the broader context? What is a bond? Historically, a bond has been viewed as a very safe investment over the long term, and, as such, they are commonly held by banks, insurance companies and pension funds. Private investors can also invest in bonds and from the perspective of a country’s Treasury, these are a very effective and important way of raising funds.

 

Once a bond is issued, the investor has the right to hold on to the bond and receive the interest each year until the bond is redeemed, with the principal amount being repaid. However, the investor can also purchase and sell bonds that have already been issued in the secondary market, which introduces the possibility of capital appreciation if these are trading at a discount and are held to maturity when the nominal value will be repaid.

 

This is similar to purchasing and selling shares in the stock market and the price of these bonds is subject to fluctuation as interest rates in the overall economy change. If the market speculates that interest rates are going to drastically increase higher than 4 per cent, the value of a bond that pays 4 percent over the next 10 years is going to drop, as the return becomes less attractive to investors.

 

The price of bonds may also drop if investors speculate that there is a possibility of the issuing government failing to either make the regular interest payments or pay the nominal or face value of the bond on the maturity date.

 

The bond yield indicates to an investor what the return on investment will be. This can be calculated based on the actual trading price of the bond in the market. For instance, if a UK bond pays 4 percent interest, i.e. £4 per £100 of bond held, and the bond can be purchased for 100 pounds, then the yield will be 4 percent. However, if the price of the bond drops to 90 pounds, the yield will increase to 4/90 = 4.44%.

 

The final way to answer the question, “What is a bond?” is to look at bond markets in general. Bond markets are vital as the risk appetite in these markets has a very strong bearing on what it will cost the government to borrow. For example, if the UK government requires to raise finance, it will issue new bonds.

 

The interest rate payable on these bonds will be determined by many factors in the market and must eventually be at a level that the market deems acceptable. The current yield in the bond market for buying and selling the government’s existing bonds gives a very good indication of the amount of interest that the government will need to pay when it seeks to raise further finance through bond issuance.

 

An Introduction to the UK Bond Market

The bond market in the United Kingdom (UK) is widely considered to be one of the most stable markets in the world today. There are plenty of reasons for this, including the relatively stable economy in the UK as well as the UK government’s track record of paying loans on time.

 

Notwithstanding this, it is very important that any potential bond investor studies the bond market in the UK to understand how it works before making any investment.

 

UK government bonds are called gilts, as they used to be issued on gilt-edged paper. The term “gilts” is used to differentiate these bonds from other types of securities that are also known as bonds and traded in the market, such as corporate bonds, time deposits and single premium life insurance policies.

 

In general, a bond is the term used to describe a monetary instrument of indebtedness issued by the bond issuer to the bondholder.

 

The bond market in the UK works in a similar manner to bond markets in other countries with bonds being issued by public authorities like the UK Treasury and local authorities, and private companies, banks, and other institutions that are raising funds by issuing this type of debt instrument.

 

Although the bonds are issued in the primary market, investors can then trade them in the secondary bond market before their maturity dates have expired.

 

Bonds are issued for a variety of reasons. For example, public authorities may use the proceeds from the sale of the gilts or bonds in the bond market to finance public debt and infrastructure projects, whereas private companies tend to use the proceeds of bond issuance for capitalisation, expansion and payment of outstanding debts.

 

No matter the purpose for which any bond is issued, all bonds must be paid in full (i.e., principal plus interest due) at the maturity date, which is similar to any other form of loan. The principal repayable is determined by the nominal amount of the bond and bonds can have fixed or variable interest rates, depending upon demand from investors.

 

Looking specifically at UK Government bonds, or gilt-edged securities, there are different types of gilts available in the bond market, including conventional gilts that are typically issued in £100 units with maturity periods in 5, 10 and 30 years although 50-year bonds and undated gilts are also available.

 

Index-linked gilts can also provide a hedge against inflation, as the payments to holders are linked to the UK Retail Price Index (RPI).

 

The UK Bond Market

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