Financial Instruments (No, hedge fund managers don’t all play in a band) – Part 1: Debt Obligations

Now that you know the main tradable assets and liabilities that drive the financial markets, let’s discuss the instruments that allow us to trade them. As explained in the previous lesson, the average individual investor won’t want gold bullion delivered to their doorstep. Thanks to advances in technology and the evolution of the financial system itself, entering the markets has never been easier for those residing in the United States. For Canadians, however, things can be slightly more complex.

Let’s get to know the different financial instruments that allow investors and traders to take part in the action of the financial markets. There are five main categories of financial instruments relevant to individual investors and traders. These are debt obligations, equity shares, funds, currency, and derivatives. Each is quite unique, and their descriptions can be quite lengthy. For this reason, this lesson is going to be split into three parts. First up, debt obligations.

Debt obligations

Debt obligations are types of contracts wherein a creditor (the investor) lends a debtor, often a company or government, a certain amount of money typically in denominations of $100 or $1000 per contract, and the debtor must repay the creditor an amount in accordance with the terms of the contract. There are many types of tradable debt obligations, the main three being the following.

Bonds

Bonds are debt obligations, typically for corporate or government debt, in which the creditor will receive repayment of the bond’s face value (purchase price, also known as par), upon the bonds maturity, along with interest on the face value. Maturity is a date assigned to the contract, and written therein. Interest on the bond comes in the form of payments of a percentage of par and are made at regular intervals until maturity. These payments are known as coupons. A firm’s failure to pay a coupon on one of its bonds allows the bond holder to force the issuer into bankruptcy, ensuring timely payment and very low risk of losing one’s investment.

One of the main things to factor into your strategy when investing in bonds is inflation. Inflation is the increase in price of goods and services over time, and varies from country to country. As inflation increases, purchasing power decreases. This means one cannot buy as much as they once could with the same amount of money. This affects bonds, especially those with long maturities, because by maturity, the payment of the bond’s face value will not have as much purchasing power as the money used to buy it when initially purchased. Thus, the return on a bond is equal to the interest rate minus the rate of inflation over the life of the bond, multiplied by the face value. Thus, if the difference between the interest and inflation is negative, the bondholder will have lost money.

One will often see a bond’s yield reported in its listing. Nominal yield, the most common calculation of yield, is the bond’s coupon payment, divided by its price. At par, the yield and interest rate of a bond are equal, but as the price of the bond differs from the purchase price, the yield differs from the interest rate and acts inversely to the price movement. For example, if the bond price increases, the yield decreases, and vice-versa.

Bonds are characterized by long maturities, low risk, and low yield. Rating agencies will issue ratings for bonds, based on their issuers. Typically, one seeks to invest in bonds with at least BBB ratings from credible rating agencies. Bonds with lower ratings, such as those of emerging markets or high yield junk bonds, are riskier investments. Bonds can either be held to maturity or sold prior to the end of its term. In addition, the interest rate of a bond can either be fixed or it may vary, as defined in the contract. Secondary market (trader to trader, instead of issuer to trader) bond prices are determined by the credit history and quality of the issuer, how much time is left until maturity, and the interest rate of the bond’s coupon compared to those of the rest of the bond’s in the market.

Notes

Notes are very much like bonds, in that they are sold on primary and secondary markets, pay interest and have a maturity date. Notes most often have a shorter term than bonds, and in addition to company and government operations, are used by banks  to finance mortgages.  They may also be used to finance both secured and unsecured (meaning the loan is secured or not secured by collateral, respectively) debts, bank deposits, agreements of payment between two entities (promissory notes) and more.

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Treasury bills

Treasury bills, often referred to as T-bills, are debt obligation contracts issued by central banks at auction. They are purchased at a discount from par, and then pay face value upon maturity.

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Of course, the aforementioned instruments can be sold prior to their maturity, as their value changes depending on several factors. In the next part of this lesson we will look at equity shares, funds and currency.

Next upChapter 2, Lesson 2: Financial Instruments (No, hedge fund managers don’t all play the cello) – Part 2: Stocks, Funds and Currency


Sources:

Image: “Marriner S. Eccles Federal Reserve Board Building” by AgnosticPreachersKid – Own work. Licensed under CC BY-SA 3.0 via Commons. Link.

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