When governments are trying to raise money for investments, they use a variety of methods to get the money. One of these ways is by lending bonds to individuals. These bonds attract interest rates and the government ends up raising the capital it needs for the short term. The money raised can be used to pay for government projects in various realms. To understand how the bond market works, you need to be familiar with various concepts. The following is a quick look at how the bond market works.
How Bonds Work
People who buy bonds from the government are qualified to earn an interest rate on their investment. This is often referred to as the bond yield. This interest is agreed on before the investment is made. Just like other forms of lending, the money that is given to the government has a maturity date. This is the period when the investment is due for return. Bonds don’t have the same maturity rates. Some are paid back in a year while others can go for several decades. The interest that is earned by the bond is called a coupon.
Types of Bonds
There are many kinds of government bonds. Most people don’t understand the different types there are though because the terminology is somewhat confusing. Depending on the country in question, the terminologies used for the bonds can be different. The common types of bonds you will find in the market include:
- Treasury bonds that expire in over a decade
- Treasury notes that expire within a decade
- Treasury bills that expire within a year
Some bonds are not tied to fixed coupons. Such bonds attract interest based on the prevailing interest rates.
How The Bonds Market Works
When it comes to trading bonds, the mechanisms that work in the financial markets are the same that influence this market too. Demand and supply forces dictate the kind of profit that a bond trader will get. The interest rate is the main determinant of the profit that a trader makes though. Sometimes, bonds in the market are said to be at par. This is so in the case where the face value of the bond is equal to the price. But when the price goes below the face value, then the bond is at a discount. On the other hand, bond trading higher than its value is said to be a premium.
Factors That Influence the Price of Bonds
As stated earlier, the bonds market works much in the same way as other trading markets. Various forces determine the prices of the bonds. Among the factors that affect price, the following are the key ones.
- Supply and demand: The bonds market works under the free market and the prices are determined by demand and supply forces. When interest rates are below the coupon rate, the bond will attract buyers since it can only attract higher rates. The reverse is also true.
- Credit ratings: Bonds are attractive to many investors because they are supplied by the government. This means that they are not as risky as other options in the market. Bonds that are risky though often attract lower prices compared to less risky ones.
- The age of the bonds: Bonds that are closer to maturity are also closer to the original value of the bond. The interest rate affects the price of the bond as time goes.
Risks Associated With Bonds
Like other trading markets, the bonds market also comes with its risks. Some of the risks in this market are related to interest rates, inflation, and currency. All these are issues that are common in the economy. The currency, inflation, and interest rates in a country can be influenced by various things and they, in turn, influence the prices of bonds.
If you are looking to get into the bonds market, you need to keep an eye on auctions. Auctions usually take place at specified times when governments and financial institutions are looking to get money from investors. Trading bonds can be beneficial when done the right way. The above information provides an overview of the bonds market and all you need to know to trade.