The US bond market is eyeing the potential benefits of a Trump administration. He promised an infrastructure spending of about 1 Trillion dollars. Deregulation of banks and repatriation of foreign dollars held overseas due to corporate tax cut from 35% to 15% by tech companies, Apple, Cisco, Google and Microsoft to the tune of about $430 B will affect the stocks and bonds alike positively, it is safe to say.

The floodgates burst open anew in the US high-grade bond market this week after Donald Trump won the White House, led by issuers in sectors expected to benefit most under his presidency.
After a two-day hiatus for one of the most momentous elections in recent memory, six borrowers jumped back into the primary, including JP Morgan Chase and Goldman Sachs.
Just hours later the Trump transition team vowed to “dismantle” Dodd-Frank, sending bank shares rocketing higher and driving financial institution paper some 3bp-5bp tighter.
Although the Trump win came as a shock after months of polls predicting he would lose handily, the US bond markets quickly digested the potential benefits of a Trump administration.

So it is a good idea to get educated on the bond fundamentals.

In general, the bond market is volatile, bond prices rise when interest rates fall and vice versa. This effect is usually pronounced for long-term securities. Any fixed-income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.

The bond market size is big compared to the stock market. $40 Trillion to $33 Trillion.
The daily trading volumes are nearly four time for the bonds. $785 Billion to $188 Billion.
The number of securities issued is 2.5 Million for the bonds as opposed to 5,300 for the stocks.
The value of the securities outstanding for example, FORD is $133 Billion for the bonds as opposed to $54 Billion for the stock
The number of issues for the same example, FORD is 257 for the bonds as opposed to just 1 for the stock
Yet, for the retail investors and traders, bonds are not as familiar as the stocks. For the institutional investors bonds are a big deal.
CUSIP stands for Committee on Uniform Securities Identification Procedures. Formed in 1962, this committee developed a system (implemented in 1967) that identifies securities, specifically U.S. and Canadian registered stocks, and U.S. government and municipal bonds.

Different types of bonds, their CUSIPs outstanding and their daily trading volumes

Mortgage backed securities – 1.6 Million Cusips – Daily Trading Volume $195 B
Municipal bonds – 695,000 Cusips – $9 B
Corporate bonds – 185,000 Cusips – $27 B
Agency bonds – 71,000 Cusips – $5 B
Treasuries – 1,095 Cusips – $490 B
As one can see, treasuries even though have very low Cusips, have the highest daily trading volume followed by mortgage backed securities which have the highest Cusips.

Yield Curves
A yield curve shows various yields offered on debt securities of the same credit quality across various maturities.
Investors who buy bonds maturing in 2025 will demand a higher yield than those getting their principal back in 2017. The longer your money is at risk, the more of a reward you demand.

In the world of fixed-income securities it is generally accepted that short-term means bonds with up to three-year maturities, intermediate-term means bonds with four to ten-year maturities, and long-term means bonds with maturities > 10 years. Typically, the longer the maturity on the bond, the higher the yield demanded by investors. If your bond matures in 2026 while mine matures in 2018, isn’t your money at risk for 8 more years? That’s why your bond would be offered at a higher yield than mine. If I buy a bond yielding 3.65%, yours might be offered at more like 3.89%. The extra 24 basis points is your extra reward for taking on extra risk.

This is how it works under a normal yield curve, where intermediate-term bonds yield more than short-term bonds and then long-term bonds yield more than both short-term and intermediate-term bonds, as well. While that is the usual state of the bond market, sometimes the rule flies out the window, and investors are suddenly receiving higher yields on short-term bonds than on intermediate- or long-term bonds. We call this situation an inverted yield curve. Or, if the yields are similar across the board for short, intermediate and long-term debt securities, the curve is said to be a flat yield curve.
A normal yield curve implies that economic conditions are stable. For the majority of its history the yield curve for U.S. Treasuries has spent its time in this particular state. A normal yield curve looks like an arc that goes up and then flattens a bit to the right. Notice that though yields are higher, they also flatten out here rather than forming a steep slope. On the other hand, a “steep yield curve” is one in which the curve buckles inward because the yields on longer maturities are so much higher than those on shorter maturities. This often happens before the economy goes into a rapid expansion. The expansion phase of the business cycle often comes along with higher interest rates and inflation, so fixed-income investors demand significantly higher yields on long-term bonds suddenly, causing a steep yield curve. We’ve seen that if the “Fed” sees inflation up ahead, they will raise interest rates. A steep yield curve suggests that this has already been factored into the bond market.
If we see the same yields among T-Bills, T-Notes, and T-Bonds, we are looking at a flat yield curve. The yield curve typically flattens when investor expectations for inflation are so low that they are not demanding higher yields to hold long-term debt securities. This will typically occur at the end of a Fed tightening cycle. At that point the Fed raises short-term interest rates until they are in line with intermediate- and long-term rates, and temporarily, with investors expecting no immediate threat from inflation, the yields are about the same across the board. A flat yield curve is thought to signal an economic slowdown. So, when the economy expands, the Federal Reserve Board typically goes into a series of interest-rate tightening. Towards the end of this cycle, the yield curve can often flatten, which usually signals the party is over for the economy, at least for a while. An inverted yield curve often follows a period of very high interest rates. When bond investors feel that interest rates have gone as high as they’re going to go, they all hurry to lock in the high interest rates for the longest period of time. In a rush of activity, they sell off their short-term bonds in order to buy long-term bonds at the best interest rate they’re likely to see for a long time. If everybody’s selling off short-term bonds, the price drops [and the yield increases]. And if they’re all buying up long-term bonds, the price increases [and the yield drops]. That causes the yield curve to invert, which is thought to be one of the surest signs that the economy is about to go into a downturn. The situation also signals lower inflation up ahead, possibly deflation.

The yield curve looks at yields over different maturities. On the other hand, the yield spread considers yields over different credit qualities— the difference in yields between high-rated and low-rated bonds. If investors are demanding a much greater yield on low-rated bonds than on high-rated bonds, that’s a negative indicator for the economy. Basically, it means investors are nervous about issuers’ ability to repay.
A corporation issuing bonds is said to be using leverage. A leveraged company has financed operations by issuing a lot of debt securities or taken out a lot of long-term bank loans. On the balance sheet, the par value of the bonds will be listed under long-term liabilities. And, on the income statement, we will see the interest payments recorded as an expense.
A bond has a specific value known as the par value or principal amount. Since it’s printed on the face of the certificate, it is also called the face amount of the bond. Bonds usually have a par value of $ 1,000 and, occasionally, $ 5,000. This is the amount an investor will receive with the very last interest payment from the issuer. Up to that point, the investor has only been receiving interest payments against the money he loaned to the corporation by purchasing their bond certificates. The bond certificate has “$ 1,000” or whatever the par value is printed on the face, along with the interest rate the issuer will pay the investor every year. This interest rate could be referred to as the coupon rate or nominal yield. Remember that the interest rate a bondholder receives is a stated, known thing.
A bond certificate is a paper or electronic document stating the details of the bond: • issuer’s name • par value or face amount • interest rate • maturity date • call date (if any)
A basis point is the smallest increment of change in a bond’s yield. When the media talks about the Fed easing interest rates by fifty basis points, they’re talking about 1/ 2 of 1 percent. We would write 1% as .01, right? Well, basis points use a 4-digit display system, so .01 is written as:

.0 1 0 0

Then, we read that figure as “100 basis points.” Two percent would be 200 basis points. One-half of one percent would be written as .0050 or “50 basis points.”
We saw that reinvestment risk is avoided by purchasing bonds that do not make regular interest payments to the investor. Such bonds are called zero coupons for obvious reasons. Each year the investor’s cost basis is accreted, but all interest income is delayed until the bond matures at a higher face amount than the investor paid. Because the value of the bond increases as opposed to the issuer paying interest, a zero coupon is also known as a capital appreciation bond. Corporate and U.S. Government zero coupon bonds are taxable annually to the investor even though interest income is not received until maturity.

Risks
Let’s do a quick review of the risks that bond investors face.

Credit/ default risk: the risk that the issuer will miss interest payments or be unable to return the principal to investors. U.S. Treasury securities lack this risk— but that’s the only investment risk they lack.

Interest rate risk: the risk that interest rates will rise, knocking bond market prices down. This is most severe on longer-term bonds.

Purchasing power risk: because the income paid on a bond is fixed, there is always the risk that inflation will erode the value of the coupon/ interest payment to the investor.

Call risk: the risk that when interest rates drop, issuers will buy back/ redeem their bonds early, eliminating the upward swing we just looked at on the bond see-saw. This forces bond investors to reinvest at lower rates going forward when they buy new bonds with the proceeds of the call. Not all bonds are callable, but those that are have this risk.
The fund rotation always happens from stocks to bonds and back depending upon whether or not the savvy investors are risk-averse or risk-loving especially for the institutional investors.

 

Courtesy: Series 65 Study Guide by Robert M. Walker; Fidelity Investments