Introduction

Bond trading plays a crucial role in financial markets, allowing investors to buy and sell debt securities issued by corporations and governments. Understanding the features of bond trading and the behavior of bond yields is essential for investors, financial analysts, and anyone interested in fixed-income securities. In this chapter, we will delve into the key characteristics of bond trading and explore how bond yields behave in response to market dynamics.

Features of Bond Trading

Bond trading involves the buying and selling of bonds in the secondary market. Bonds are traded on various exchanges, over-the-counter (OTC) platforms, and electronic trading platforms. Here are some important features of bond trading:

Market Price and Par Value: Bonds are typically issued at a par value (also known as face value) and can trade in the secondary market above, below, or at par. The market price of a bond is influenced by factors such as interest rates, credit risk, and prevailing market conditions.

Yield to Maturity (YTM): YTM represents the total return an investor can expect to receive if they hold a bond until maturity. It considers the bond’s current market price, coupon payments, and the difference between the purchase price and the par value.

Coupon Payments: Bonds pay periodic interest payments known as coupon payments. The coupon rate is the annual interest rate expressed as a percentage of the bond’s par value. For example, a USD 1,000 par value bond with a 5% coupon rate would pay USD 50 in annual coupon payments.

Price Sensitivity to Interest Rates: Bond prices are inversely related to prevailing interest rates. When interest rates rise, existing bonds with lower coupon rates become less attractive, leading to a decrease in their market prices. This phenomenon is known as interest rate risk.

Behavior of Bond Yield

Bond yield refers to the effective return an investor receives from a bond, taking into account its market price and coupon payments. Understanding how bond yields behave is crucial for assessing investment opportunities and making informed decisions.

• Yield Inverse Relationship with Price: As bond prices increase, yields decrease, and vice versa. This inverse relationship reflects the fact that as bond prices rise, investors receive less interest income relative to the higher purchase price.

• Impact of Coupon Rate: Bonds with higher coupon rates generally have lower yield volatility than those with lower coupon rates. This is because the higher coupon payments provide a cushion against changes in market prices.

• Yield Curve: The yield curve is a graphical representation of bond yields across different maturities. It can be upward-sloping (longer maturities have higher yields), flat (similar yields across maturities), or inverted (shorter maturities have higher yields). Changes in the yield curve provide insights into market expectations about future interest rates.