Convertible bonds are bonds issued by companies that give the bondholder the option to buy the company’s stock at a predetermined price. Convertible bonds are bonds with stock options. The investor typically gets a lower rate of return but can trade the bond for stock rather than be repaid the cost of the bond. The holder of the bonds can buy stocks at a predetermined price.

The successful trader learns how to size his trades correctly, how to pick stop loss and take profit levels, and is nimble. He does not let greed and fear make his trading decisions, and he does not freeze during moments of market panic. He never ‘‘bets the farm’’ on any one single trade and is constantly challenging and reexamining his own convictions. These trading disciplines cannot be imbibed in a classroom setting; they are only mastered in the heat of battle.

The main objective of Inflation-Indexed Bonds is to provide a hedge and to safeguard the investor against macroeconomic risks in an economy. The different structures of inflation-indexed bonds include the following:

– Indexed-annuity bonds: Fully amortizing bonds with the periodic payments directly adjusted for inflation or deflation.
– Indexed zero-coupon bonds: The payment at maturity is adjusted for inflation.
– Interest-indexed bonds: The coupon rate is adjusted for inflation while the principal value remains unchanged.
– Capital-indexed bonds. This is the most common structure. An example is U.S. Treasury Inflation Protected Securities (TIPS). The coupon rate remains constant, and the principal value of the bonds is increased by the rate of inflation (or decreased by deflation).

The pension funds, high net worth individuals, banks, and endowments are the people with the money who have made the decision to invest in hedge funds. Sometimes these investors will invest directly in the hedge funds, but most of the time they will outsource the due diligence and hedge fund picking activity to an expert, like a fund of funds.

The layers of middlemen are in the form of consultants, advisors, fund of funds, and third-party marketers. These layers of middlemen have made fortunes trying to match investors with the appropriate hedge fund managers.

Analyzing, buying, and selling stocks or even bonds and money market funds is a transparent, cheap, and easy process but investing in hedge funds is a lot more complex. Hedge funds are financial partnerships that use pooled funds and employ different strategies to earn active returns for their investors. These funds may be managed aggressively or make use of derivatives and leverage to generate higher returns.

Upon maturity of the bond, holders will receive back the initial principal amount in addition to the interest paid. There are three sources of returns from investing in a fixed-rate bond:

– Coupon and principal payments.
– Interest earned on coupon payments that are reinvested over the investor’s holding period for the bond.
– Any capital gain or loss if the bond is sold prior to maturity.

A key rate duration, also known as a partial duration, refers to the sensitivity of the value of a bond or portfolio to changes in the spot rate for a specific maturity, holding other spot rates constant. A bond or portfolio will have a key rate duration for each maturity range on the spot rate curve.

Credit risk refers to the risk associated with losses stemming from the failure of a borrower to make timely and full payments of interest or principal. Credit risk has two components: default risk and loss severity.

Notching refers to the practice by rating agencies of assigning different ratings to bonds of the same issuer. Notching is based on several factors, including the seniority of the bonds and its impact on potential loss severity.

Bonds are the most common type of fixed-income security, but others include CDs, money markets, and preferred shares. The features of a fixed-income security include specification of the following:

– The issuer of the bond.
– The maturity date of the bond.
– The par value (principal value to be repaid).
– Coupon rate and frequency.
– Currency in which payments will be made.

Once a bond has been issued, the time remaining until maturity is referred to as the term to maturity or tenor of a bond. When bonds are issued, their terms to maturity range from one day to 30 years or more.

Perpetual bonds refer to bonds that have no maturity date. Perpetual bonds make periodic interest payments but do not promise to repay the principal amount.

The par value of a bond is the principal amount that will be repaid at maturity. The par value is also referred to as the face value, maturity value, redemption value, or principal value of a bond. Bonds can have a par value of any amount, and their prices are quoted as a percentage of par. A bond with a par value of $1,000 quoted at 98 is selling for $980.

A bond that is selling for more than its par value is said to be trading at a premium to par. A bond that is selling for more than its par value costs more than the face amount on the bond. A bond might trade at a premium to par because its interest rate is higher than current rates in the market.

A bond that is selling at less than its par value is said to be trading at a discount to par. A distressed bond trading at a significant discount to par can effectively raise its yield to attractive levels. Bonds selling at a discount to par may indicate the belief that the underlying company may default on their debt obligations.

A bond that is selling for exactly its par value is said to be trading at par. A bond that was trading at par would be quoted at 100, meaning that it traded at 100% of its par value. A bond that trades at par has a yield equal to its coupon. Investors expect a return equal to the coupon for the risk of lending to the bond issuer.

The coupon rate on a bond is the annual percentage of its par value that will be paid to bondholders. Some bonds make coupon interest payments annually, while others make semiannual, quarterly, or monthly payments. A $1,000 par value semiannual-pay bond with a 5% coupon would pay 2.5% of $1,000, or $25, every six months.

A bond with a fixed coupon rate is called a plain vanilla bond or a conventional bond. A plain vanilla bond is the most basic type of bond, wherein when an investor buys a bond, there is a fixed coupon payment at pre-determined fixed intervals, and the maturity of the bond is also pre-determined. Plain vanilla bonds are easier to trade, and they have tighter spreads.

Bonds that pay no interest prior to maturity are called zero-coupon bonds or pure discount bonds. Pure discount refers to the fact that these bonds are sold at a discount to their par value and the interest is all paid at maturity when bondholders receive the par value.

The legal contract between the bond issuer (borrower) and bondholders (lenders) is called a trust deed, and in the United States and Canada, it is also often referred to as the bond indenture. The indenture defines the obligations of and restrictions on the borrower and forms the basis for all future transactions between the bondholder and the issuer.

The provisions in the bond indenture are known as covenants and include both negative covenants and affirmative covenants. Bond covenants are part of the legal documentation that makes up a bond, whether it is issued by a company or the government. They are usually intended to protect investors by providing some assurance on what the bond issuer will and won’t do over the life of the bond.

Negative covenants include restrictions on asset sales (the company can’t sell assets that have been pledged as collateral), negative pledge of collateral (the company can’t claim that the same assets back several debt issues simultaneously), and restrictions on additional borrowings (the company can’t borrow additional money unless certain financial conditions are met). Negative covenants serve to protect the interests of bondholders and prevent the issuing firm from taking actions that would increase the risk of default. At the same time, the covenants must not be so restrictive that they prevent the firm from taking advantage of opportunities that arise or responding appropriately to changing business circumstances.

Affirmative covenants do not typically restrict the operating decisions of the issuer. Common affirmative covenants are to make timely interest and principal payments to bondholders, to insure and maintain assets, and to comply with applicable laws and regulations.

Bonds issued by a firm domiciled in a country and also traded in that country’s currency are referred to as domestic bonds. The market where the issuers domiciled within the country issue the bonds and where these bonds are traded is referred to as the domestic bond market.

Bonds issued by a firm incorporated in a foreign country that trade on the national bond market of another country in that country’s currency are referred to as foreign bonds. Examples include bonds issued by foreign firms that trade in China and are denominated in yuan, which are called panda bonds, and bonds issued by firms incorporated outside the United States that trade in the United States and are denominated in U.S. dollars, which are called Yankee bonds.

Eurobonds are issued outside the jurisdiction of any one country and denominated in a currency different from the currency of the countries in which they are sold. They are subject to less regulation than domestic bonds in most jurisdictions and were initially introduced to avoid U.S. regulations. Eurobonds should not be confused with bonds denominated in euros or thought to originate in Europe, although they can be both. Eurobonds got the “euro” name because they were first introduced in Europe, and most are still traded by firms in European capitals.

Some bonds pay periodic interest that depends on the current market rate of interest. These bonds are called floating-rate notes (FRN) or floaters. Floating rate notes or floaters can be issued by financial institutions, governments, and corporations in maturities of two-to-five years.

Inflation-linked bonds (also called linkers) are the most common type of index-linked bonds. Their payments are based on the change in an inflation index, such as the Consumer Price Index (CPI) in the United States. Indexed bonds that will not pay less than their original par value at maturity, even when the index has decreased, are termed principal protected bonds.

With a deferred coupon bond, also called a split coupon bond, regular coupon payments do not begin until a period of time after issuance. These are issued by firms that anticipate cash flows will increase in the future to allow them to make coupon interest payments. Deferred coupon bonds may be appropriate financing for a firm financing a large project that will not be completed and generating revenue for some period of time after bond issuance. Deferred coupon bonds may offer bondholders tax advantages in some jurisdictions.