Bond trading and investing has traditionally been for the professional investor and those seeking a steady income from their investment portfolio. The actual bond market is quite different from the stock market and this article seeks to help you understand how the bond market works.

A bond is simply evidence of a loan. If you want to loan ABC company some money then you would buy a bond issued by ABC. The bond is evidence of the loan and it will state what rate of interest is paid to the holder of the bond and it will also state the date on which the bond matures and the full amount of the original loan will be repaid to the bond holder. For our example we will assume the bond pays 10% interest annually. Bonds normally pay interest twice a year so every 6 months this bond will pay the holder 5% of the face amount of the bond. For our example we’ll assume a \$1000 bond at 10% annual interest will pay the holder \$50 every 6 months. In this case the bond yield is 10%.

Simplistically, that’s all there is to a bond. There’s no rocket science involved in the actual ownership of bonds. You make a loan to a company (or a government) and you collect semi-annual interest payments until the bond matures, at which time you get your original investment amount back.

The rocket science related to bond investing really takes place on the secondary market.

The term secondary market simply refers to the market which exists for bonds that investors do not wish to hold until maturity. If you own a bond and have been collecting semi-annual interest payments, you may decide that you want to sell the bond to another investor at anytime in order to get some cash in hand. The question then becomes, what is the bond worth on the secondary market?

Secondary market bond prices are determined by, among other things, the prevailing level of interest rates and the perceived credit-worthiness of the company (or government) that issued the bond. To use our example numbers from above, if the level of interest rates goes from 10% to 5% then the price of the outstanding bond will adjust in the market place so the bond yield will more closely match the current interest rate environment.

In the example, our \$1000 bond at 10% will pay the holder an annual income of \$100, but in a lower rate environment a new buyer of that existing bond could only expect to receive income more in line with the current interest rate (ie 5%) so the price of the bond on the secondary market will rise to a level where the annual income (bond yield) received by the new buyer is closer to 5% (in the example the \$1000 bond purchased when rates were high could theoretically be worth close to \$2000 in the secondary market when rates are much lower and this is how money is made and lost by investors and speculators on the secondary bond market).

Generally speaking, as interest rates decline, the price of bonds on the secondary market increases and as interest rates rise, secondary market bond prices go down.

Making money in the bond market depends on your ability to gauge the future direction of interest rates among other factors. Holding a bond to maturity can remove you from the rough and tumble of rising and falling prices, but you may give up profit opportunities in the secondary market using a strictly passive bond investment style.

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