The name is Bond - Junk Bond!

OK. I get it. That tagline is cheesy. However, it was too good to not use. Spectre released two days ago and this article is about bonds. Hence.

So, lets talk bonds. There has been a lot of news recently with the strong jobs report in October and multiple indications of a rate raise in either December or March. Nevertheless, the bond market has seen wide fluctuations in the recent months. Let us take a look at what bonds are and the reasons behind these fluctuations.

A bond is a loan that pays interest over a period of time. When the bond matures at the end of the term, the principal is repaid to the owner of the bond. The rate of interest and the amount of each payment is always fixed at the time the bond is offered for sale. Hence, they are also referred to as fixed-income securities. The rate of interest offered depends on the rating of the bonds (I will explain this below), what other bonds being issued are paying as well as the cost of borrowing in the economy.

There are different types of bonds one can buy. This includes corporate bonds which are issued by US companies, US treasury bonds as well as Municipal bonds. Corporate bonds are typically sold at par value, usually in the units of $1,000. Once these bonds are issued, they can be traded in secondary market. This means they can be bought and sold by traders depending on how well the company is doing or the market is performing.  Government bonds are available directly through a program called Treasury Direct. It can be accessed at http://www.treasurydirect.gov
Municipal bonds are typically sold brokers in large denominations ($25,000) who then sell them to individual investors in smaller denominations.

Bonds get rated by two agencies - Moody's and Standard and Poor's. Their rating ranges from AAA (Best quality with lowest risk) to D (Imminent default). The different ratings are AAA, AA, A, BBB, BB, B, CCC, CC, C and D. The rate of interest offered is influenced by the rating. A bond rated AAA offers the lowest rate compared to a bond rated BB (as it has a higher risk). Only Corporate Bonds and Municipal Bonds are rated. US Treasury bonds are not rated as it is assumed they are obligations of the federal government and backed by the faith and authority it has to raise taxes to pay off its debts.

This brings us to our tagline - Junk Bond. Recently you might have noticed the bond market is getting smoked. German Bund has been on a free fall and US treasury have lost its lustre recently. This is because there is speculation of an imminent raise in interest rates by the Federal Reserve. If you are confused, let me explain.

Lets say you bought one bond in November, 2015 with a par value of $1,000 and rate of interest of 1 percent for 5 years. So every year, you expect to be paid $10 for a period of 5 years and a face value or par value of $1,000 at the end of 5 years. This brings a total return of $1,050 at the end of 5 years. Suppose the Federal Reserve raises its interest rate of 2 percent by 2016 January. The bond you are holding is then paying lesser than what is offered in the economy and becomes less attractive as an investment. This leads to selling in the secondary market at a discount or a loss as investors would like to invest their money in securities with a higher return. As a result, the yield percent of bond has fallen. In such an economy, if the US company were to issue new bonds to raise capital, it must offer a higher return. And existing bonds become - Junk Bond!!!