How Bond Works, Bonds trading its Relation to Crisis in Europe

While the stock markets are extensively covered in the print as well as on television and internet, the bond markets rarely get any coverage. Most of times such thing would happen if the market for the bonds itself is not large. However that is not the case. You will be surprised to know that the bond markets in most economies of the world are as large as stock markets and in fact many times larger in a number of countries. So how is it that not many talk about it or its not well covered. It is simple because of the following factors: a) It is more complicated to understand compared to stocks b) Stakes are very high even in a minimum denomination transaction making it very risky for small investors c) The risks and returns are exponential in nature much in the same way as in case of derivatives d) It is less understood, used mostly by bankers, institutional investors and other very large financial agencies. To start with, let us define Bond first. The dictionary meaning is a promise or a commitment. Therefore when a company or an institution issues a bond, it thereby agrees to commit to all the terms of the bond. The bond typically requires the investor to deposit certain amount of money with the bond issuer in return for the promise which invariably includes return of the capital after a stipulated time and payment of interest at regular intervals till the end of the bond tenure. A little variation in it is that in place of interest being paid regularly the company can offer to pay a lump sum amount along with the capital at the end of the tenure. Now the two options that I gave you are like plain vanilla ice cream in the world of bonds. There are hundreds of variations and business models within the sphere of bonds that make them a little complicated for most of us. But I will try to unravel the secrets in a phased and slow manner so that we all can understand them. Now the bigger the company issuing the bonds, more reliable and trustworthy it will be and less returns they will be offering since they will be having many takers even at lower returns. However smaller companies with relatively lesser proven records will need to offer higher interest rates to attract adequate investors. For investors, the risk is increased or reduced two times over. In a bigger company, not only is the company more stable, lower returns ensure the company will be in a relatively better position to honour or repay the bond commitments.

The investors therefore need to invest in a company depending upon their risk appetite and their assessment of the company. The advertisements that you see of various companies asking general public to invest in the 1/2/5 year deposit schemes are nothing but company bonds. Technically these bonds post issuance and till the maturity can be traded on bourses much in the same way as stocks. But practically there is very little interest in company bonds in the bond trade markets where players prefer to trade only on sovereign bonds Sovereign bonds are bonds that are issued by the government of the country and hence are considered the safest bonds. Since it is always possible for the largest of companies to go bankrupt but rarely does it happen that an entire nation is defaulting or tending to default. The safety and stability of these bonds make them ideal for trading on bond bourses. I will be covering more on the sovereign bonds and bond trading in my subsequent blogs. Keep reading. I am sure that at the end of the series, you will be in a position to take a lecture on bonds even for the IIM graduates!