What is a Bond?

In finance, a bond is a debt security, in which the issuer owes the holders a debt and is obliged to repay the principal and interest (the coupon) at a later date, termed maturity.
Other stipulations may also be attached to the bond issue, such as the obligation for the issuer to provide certain information to the bond holder, or limitations on the behavior of the issuer. Bonds are generally issued for a fixed term (the maturity) longer than ten years. U.S Treasury securities issued debt with life of ten years or more is a bond. New debt between one year and ten years is a note, and new debt less than a year is a bill.

A bond is simply a loan, but in the form of a security, although terminology used is rather different. The issuer is equivalent to the borrower, the bond holder to the lender, and the coupon to the interest. Bonds enable the issuer to finance long-term investments with external funds. Certificates of deposit (CDs) or commercial paper are considered money market instruments.

Traditionally, the U.S. Treasury uses the word bond only for their issues with a maturity longer than ten years, and calls issues between one and ten year notes. Elsewhere in the market this distinction has disappeared, and both bonds and notes are used irrespective of the maturity.
Market participants normally use bonds for large issues offered to a wide public, and notes for smaller issues originally sold to a limited number of investors. There are no clear demarcations. There are also "bills" which usually denote fixed income securities with three years or less, from the issue date, to maturity. Bonds have the highest risk, notes are the second highest risk, and bills have the least risk. This is due to a statistical measure called duration, where lower durations have less risk, and are associated with shorter term obligations.

Bonds and stocks are both securities, but the difference is that stock holders own a part of the issuing company (have an equity stake), whereas bond holders are in essence lenders to the issuer. Also bonds usually have a defined term, or maturity, after which the bond is redeemed whereas stocks may be outstanding indefinitely. An exception is a consol bond, which is a perpetuity (i.e. bond with no maturity).

Issuers

The range of issuers of bonds is very large. Almost any organization could issue bonds, but the underwriting and legal costs can be prohibitive. Regulations to issue bonds are very strict. Issuers are often classified as follows:

• Supranational agencies, such as the European Investment Bank or the Asian Development Bank issue supranational bonds.
• National Governments issue government bonds in their own currency. They also issue sovereign bonds in foreign currencies.
• Sub-sovereign, provincial, state or local authorities (municipalities). In the U.S. state and local government bonds are known as municipal bonds.
• Government sponsored entities. In the U.S., examples include the Federal Home Loan Mortgage Corporation (Freddie Mac), the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Banks. The bonds of these entities are known as agency bonds, or agencies.
• Companies (corporates) issue corporate bonds.
• Special purpose vehicles are companies set up for the sole purpose of containing assets against which bonds are issued, often called asset-backed securities.

Trading and valuing bonds

The interest rate that the issuer of a bond must pay is influenced by a variety of factors, such as current market interest rates, the length of the term and the credit worthiness of the issuer.

These factors are likely to change over time, so the market value of a bond can vary after it is issued. Because of these differences in market value, bonds are priced in terms of percentage of par value.
Bonds are not necessarily issued at par (100% of face value, corresponding to a price of 100), but all bond prices converge to par when they reach maturity. At other times, prices can either rise (bond is priced at greater than 100), which is called trading at a premium, or fall (bond is priced at less than 100), which is called trading at a discount.
Most government bonds are denominated in units of $1000, if in the United States, or in units of £100, if in the United Kingdom. Hence, a deep discount US bond, selling at a price of 75.26, indicates a selling price of $752.60 per bond sold. (Often, bond prices are quoted in points and thirty-seconds of a point, rather than in decimal form.)
Some short-term bonds, such as the U.S. T-Bill, are always issued at a discount, and pay par amount at maturity rather than paying coupons. This is called a discount bond.

The market price of a bond is the present value of all future interest and principal payments of the bond discounted at the bond's yield, or rate of return. The yield represents the current market interest rate for bonds with similar characteristics. The yield and price of a bond are inversely related so that when market interest rates rise, bond prices generally fall and vice versa.

The market price of a bond may include the accrued interest since the last coupon date. (Some bond markets include accrued interest in the trading price and others add it on explicitly after trading.) The price including accrued interest is known as the "flat" or "dirty price". (See also Accrual bond.) The price excluding accrued interest is sometimes known as the Clean price.

The interest rate adjusted for the current price of the bond is called the "current yield" or "earnings yield" (this is the nominal yield multiplied by the par value and divided by the price).

Taking into account the expected capital gain or loss (the difference between the current price and the redemption value) gives the "redemption yield": roughly the current yield plus the capital gain (negative for loss) per year until redemption.

The relationship between yield and maturity for otherwise identical bonds is called a yield curve.

Bonds markets, unlike stock or share markets, often do not have a centralized exchange or trading system. Rather, in most developed bond markets such as the U.S., Japan and western Europe, bonds trade in decentralized, dealer-based over-the-counter markets. In such a market, market liquidity is provided by dealers and other market participants committing risk capital to trading activity. In the bond market, when an investor buys or sells a bond, the counterparty to the trade is almost always a bank or securities firm acting as a dealer.
In some cases, when a dealer buys a bond from an investor, the dealer carries the bond "in inventory." The dealer's position is then subject to risks of price fluctuation. In other cases, the dealer immediately resells the bond to another investor.

Bond markets also differ from stock markets in that investors generally do not pay brokerage commissions to dealers with whom they buy or sell bonds. Rather, dealers earn revenue for trading with their investor customers by means of the spread, or difference, between the price at which the dealer buys a bond from one investor--the "bid" price--and the price at which he or she sells the same bond to another investor--the "ask" or "offer" price.
The bid/offer spread represents the total transaction cost associated with transferring a bond from one investor to another.

What is the S&P 500?

S&P 500 is an index containing the stocks of 500 Large-Cap corporations, most of which are American. The index is the most notable of the many indices owned and maintained by Standard & Poor's, a division of McGraw-Hill. S&P 500 is used in reference not only to the index but also to the 500 actual companies whose stocks are included in the index.

The S&P 500 index forms part of the broader S&P 1500 and S&P Global 1200 stock market indices.

All of the stocks in the index are those of large publicly held companies and trade on major US stock exchanges such as the New York Stock Exchange and Nasdaq. After the Dow Jones Industrial Average, the S&P 500 is the most widely watched index of large-cap US stocks. It is considered to be a bellwether for the US economy and is a component of the Index of Leading Indicators.

Many index funds and exchange-traded funds track the performance of the S&P 500 by holding the same stocks as the index, in the same proportions, and thus attempting to match its performance (before fees and expenses). Partly because of this, a company which has its stock added to the list may see a boost in its stock price as the managers of the mutual funds must purchase that company's stock in order to match the funds' composition to that of the S&P 500 index.

In stock and mutual fund performance charts, the S&P 500 index is often used as a baseline for comparison. The chart will show the S&P 500 index, with the performance of the target stock or fund overlaid.

History

Prior to 1957, the primary S&P stock market index consisted of 90 companies, known as the S&P 90, and was published on a daily basis. A broader index of 423 companies was also published weekly. On March 4, 1957, a broad, real-time stock market index, the S&P 500 was introduced. This introduction was made possible by advancements in the computer industry which allowed the index to be calculated and disseminated in real time.

The S&P 500 is used widely as an indicator of the broader market, as it includes both "growth" stocks (which inflated and then deflated in the dot-com bubble and bust) and generally less volatile "value" stocks; it also includes stocks from both the NASDAQ stock market and the NYSE.
The index, near the height of the bubble, reached an all-time closing high of 1,527.46, and intra-day high of 1,553.11, on March 24, 2000. After that, the index eventually lost approximately 50% of its value, spiking below 800 in July 2002 and reaching a bear market low of 768.63 intra-day on October 10, 2002.
Since then, the US stock markets have gradually recovered. However, during the week of October 2, 2006, when the DJIA set new record highs for the first time in nearly seven years, the S&P 500 remained below its all-time closing high. As of late 2006, the S&P 500 remains below its all-time high, although it established a monthly close above 1400 points for the first time in over six years on November 30, 2006.

Selection

The components of the S&P 500 are selected by committee. This is similar to the Dow 30, but different from others such as the Russell 1000, which are strictly rules-based.

Although the index includes many large companies in the US, it is not simply a list of the 500 biggest companies, and includes a handful (11 as of September 19, 2006) that are incorporated outside of the US and are therefore technically not US companies.
The companies are carefully selected to ensure that they are representative of various industries in the US economy. In addition, companies that do not trade publicly (such as those that are privately or mutually held) and stocks that do not have sufficient liquidity are not in the index.
By contrast, the Fortune 500 attempts to list the 500 largest companies in the United States by gross revenue, regardless of whether their stocks trade or their liquidity, without adjustment for industry representation, and excluding companies incorporated outside the US.

See a list o S&P 500 companies

What is the Dow Jones?

Dow Jones Industrial Average (NYSE: DJI, also called DJIA, Dow 30, or informally the Dow Jones index or the Dow) is one of several stock market indices created by Wall Street Journal editor and Dow Jones & Company founder Charles Dow.

Dow compiled the index as a way to gauge the performance of the industrial component of America's stock markets. It is the oldest continuing U.S. market index. Today, the average consists of 30 of the largest and most widely held public companies in the United States.
The "industrial" portion of the name is largely historical - many of the 30 modern components have little to do with heavy industry. To compensate for the effects of stock splits and other adjustments, it is currently a scaled average, not the actual average of the prices of its component stocks - the actual average of prices is multiplied by a scale factor, which changes over time, to generate the value of the index.

History

First published on May 26, 1896, the DJIA represented the average of twelve stocks from various important American industries. Of those original twelve, only General Electric remains part of the average. The other eleven were:

• American Cotton Oil Company, a predecessor of Bestfoods, now part of Unilever
• American Sugar Company, now Amstar Holdings
• American Tobacco Company, broken up in 1911
• Chicago Gas Company, bought by Peoples Gas Light & Coke Co. in 1897 (now Peoples Energy Corporation)
• Distilling & Cattle Feeding Company, now Millennium Chemicals, a division of Lyondell Chemical Company
• Laclede Gas Light Company, still in operation as The Laclede Group
• National Lead Company, now NL Industries
• North American Company, (Edison) electric company broken up in the 1950s
• Tennessee Coal, Iron and Railroad Company, bought by U.S. Steel in 1907
• U.S. Leather Company, dissolved 1952
• United States Rubber Company, changed its name to Uniroyal in 1967, bought by Michelin in 1990

When it was first published, the index stood at 40.94. It was computed as a direct average, by first adding up stock prices of its components and dividing by the number of stocks. Many of the biggest percentage price moves in the Dow occurred early in its history, as the nascent industrial economy matured.

• The index hit its all-time low of 28.48 during the summer of 1896.
• The largest one-day percentage drop in the history of the Dow occurred on December 12, 1914, 24.39%, after a multi-month NYSE hiatus brought on by World War I.

In 1916, the number of stocks in the DJIA was increased to twenty, and finally to thirty in 1928, near the height of the "roaring 1920s" bull market. The crash of 1929 and the ensuing Great Depression returned the average to its starting point, almost 90% below its peak, by July 8, 1932. The highs of September 3, 1929 would not be surpassed until 1954.

• The largest one-day percentage gain in the index, 14.87%, happened on October 6, 1931, in the depths of the 1930s bear market.
• The post-World War II bull market, which brought the market well above its 1920s highs, lasted until 1966.
• On November 14, 1972 the average closed above 1,000 (1,003.16) for the first time, in the midst of a lengthy bear market.

The 1980s and especially the 1990s saw a very rapid increase in the average, though severe corrections did occur along the way.

• The largest one-day percentage drop since 1914 occurred on "Black Monday", October 19, 1987, when the average fell 22.6%.
• The largest one-day percentage gain since 1932, 10.15%, occurred two days later on Wednesday, October 21, bringing the Dow back above 2,000 and in line for a yearly gain.
• On November 21, 1995 the DJIA closed above 5,000 (5,023.55) for the first time.
• On March 29, 1999, the average closed at 10,006.78, its first close above the 10,000 mark.
• On May 3, 1999, the Dow closed at 11,014.70, its first close above 11,000.

The uncertainty of the early 2000s brought a significant bear market, and whether it has ended or simply gone into hibernation has been an ongoing subject of debate.

• On January 14, 2000, the DJIA reached a record high of 11,750.28 in trading before settling at a record closing price of 11,722.98; these two records would not be broken until October 3, 2006.
• The largest one-day point gain in the Dow, an advance of 499.19, or 4.93%, occurred on March
• 16, 2000, as the broader market approached its top.
• The largest one-day point drop in DJIA history occurred on September 17, 2001, the first day of trading after the September 11, 2001 attacks, when the Dow fell 684.81 points, or 7.1%. By the end of that week, the Dow had fallen 1,369.70 points, or 14.3%. A recovery attempt allowed the average to close the year above 10,000.
• By mid-2002, the average had returned to its 1998 level of 8,000.
• On October 9, 2002, the DJIA bottomed out at 7,286.27 (intra-day low 7,197.49), its lowest close since October 1997.
• By the end of 2003, the Dow returned to the 10,000 level.
• On January 9, 2006 the average broke the 11,000 barrier for the first time since June 2001, closing at 11,011.90.
• In October 2006, four years after its bear market low, the DJIA set fresh record theoretical, intra-day, daily close, weekly, and monthly highs for the first time in almost seven years, closing above 12,000 for the first time on the 19th anniversary of Black Monday.
• On February 27, 2007, the Dow Jones Industrial Average fell 415.30 points, closing at 12,216.96, the biggest point drop since September 17, 2001, the first day of trading after the September 11, 2001 attacks.

The individual components of the DJIA are occasionally changed as market conditions warrant. They are selected by the editors of The Wall Street Journal.
When companies are replaced, the scale factor used to calculate the index is also adjusted so that the value of the average is not directly affected by the change.
On November 1, 1999, Chevron, Goodyear Tire and Rubber Company, Sears Roebuck, and Union Carbide were removed from the DJIA and replaced by Intel, Microsoft, Home Depot, and SBC Communications. Intel and Microsoft became the first two companies traded on the NASDAQ exchange to be listed in the DJIA.
On April 8, 2004, another change occurred as International Paper, AT&T, and Eastman Kodak were replaced with Pfizer, Verizon, and AIG. On December 1, 2005 AT&T's original T symbol returned to the DJIA as a result of the SBC Communications and AT&T merger.


See how the Dow Jones is calculated
See a list of DOW companies

What is the NASDAQ?

NASDAQ (originally an acronym for National Association of Securities Dealers Automated Quotations system) is an American electronic stock exchange, founded in 1971 by the National Association of Securities Dealers (NASD), who divested it in a series of sales in 2000 and 2001.

It is owned and operated by The Nasdaq Stock Market, Inc., the stock of which was listed on its own stock exchange in 2002.
NASDAQ is the largest electronic screen-based equity securities market in the United States. With approximately 3,200 companies, it lists more companies and, on average, trades more shares per day than any other U.S. market.

Its current chief executive officer is Robert Greifeld.

History

When it began trading on February 8, 1971, it was the world's first electronic stock market. At first, it was merely a computer bulletin board system and did not actually connect buyers and sellers. The NASDAQ helped lower the spread (the difference between the bid price and the ask price of the stock) but somewhat paradoxically was unpopular among brokerages because they made much of their money on the spread. Over the years, NASDAQ became more of a stock market by adding trade and volume reporting and automated trading systems. NASDAQ was also the first stock market to advertise to the general public, highlighting NASDAQ-traded companies (usually in technology) and closing with the declaration that NASDAQ is "the stock market for the next hundred years."

By 1975, the NASDAQ displayed only NASDAQ-listed stocks, separating itself from other OTC stocks. Five years later the NASDAQ began displaying inside quotations, which showed the market’s best bid and best sell prices on screen. This basically kept the market makers honest, and published spreads (margin between the best bid and best sell) declined on more than 85% of NASDAQ stocks.

From 1982 - 1986, the NASDAQ’s top companies broke away from the smaller ones, forming the NASDAQ National Market. This new market offered traders real-time quotes on stocks, and also offered margin to traders, meaning they could now purchase these stocks on credit with their brokers.

Until 1987, most trading occurred via the telephone, but during the October 1987 stock market crash, market makers often didn't answer their phones. To counteract this, the Small Order Execution System (SOES) was established, which provides an electronic method for dealers to enter their trades. NASDAQ requires market makers to honor trades over SOES.[2]

On July 17, 1995, the NASDAQ Composite index closed above the 1,000 mark for the first time. The index peaked at an intra-day high of 5,132.52 on March 10, 2000, which signaled the beginning of the end of the dot-com stock market bubble. The index declined to half its value within a year, and finally found a bear market bottom at its intra-day low of 1,108.49 on October 10, 2002. While the index has gradually recovered since then, reaching a six-year monthly closing high above the 2,400 level on November 30, 2006, it is still (as of early 2007) trading for less than half of its peak value.

NASDAQ allows multiple market participants to trade through its Electronic Communication Networks (ECNs) structure, increasing competition. The Small Order Execution System (SOES) is another NASDAQ feature, introduced in 1987, to ensure that in 'turbulent' market conditions small market orders are not forgotten but are automatically processed. With approximately 3,200 companies, it lists more companies and, on average, trades more shares per day than any other stock exchange in the world. It is home to companies that are leaders across all areas of business including technology, retail, communications, financial services, digging, transportation, media and biotechnology. NASDAQ is the primary market for trading NASDAQ-listed stocks.

See hystorical charts
See a list of NASDAQ companies

Traders are chewing their nails... "To trade or not to trade"

The market was swept up in a wave of relief last week, as traders chewed their nails ahead of both the Federal Open Market Committee meeting and the January non-farm payroll report.

The week certainly didn't start off on the right foot as a number of large-cap companies were taken behind the woodshed following their respective earnings reports.

Yet, some interesting things developed despite this weak start. First, the small-cap Russell 2000 Index (RUT) finally conquered the 800 level. This region has been a nagging thorn in the side of the index since the beginning of December. On Friday, the RUT tagged a new all-time high of 810.35.

Of course, the RUT wasn't the only one making gains. The Dow Jones industrial average hit a new all-time high of 12,683.9 last Friday, while the Standard & Poor's 500 Index notched a new multiyear high of 1,449.33.
Meanwhile, the Nasdaq 100 Trust is holding at support at its 80-day trend line and above peak put open interest at the 44 strike in the February series.

While the market continues to skip higher, we are still seeing signs of growing pessimism among investors. The New York Stock Exchange short-interest ratio popped in January from 6.3 to 6.8 as the number of bearish bets swelled. Furthermore, the odd-lot shorts coming into the past trading week hovered at 6-month highs.

In addition, a recent article in The Wall Street Journal described a huge movement among investors into cash. This certainly raises the question of whether John Q. Investor or John Q. Planner moving heavy into cash is a good contrary indicator. I'd have to say "yes."

Back in the early 1980s, when money market yields reached 17%, fortunes were made by those who either bought long bonds or bought stocks. But the vast majority of investors stuck with money market funds and just sat and watched while their yields tumbled and their principal stagnated.

I'll add that in the mid-1990s (right before the bull market took off), a consensus developed that "stocks cannot compete with 8% bond yields." Is anyone surprised that we are seeing big moves into cash?

One obstacle that remains ahead of the market is the 670 level hovering above the S&P 100 Index (OEX). This region capped the index's rally attempts in late January and again last week. But with pessimism on the rise in the face of the broad market's strength, this is just another roadblock that will likely be hurdled with the same persistence that pushed the RUT through 800.

U.S. ECONOMY: Is all that growth just hot air?

After a weak patch in the fall, the U.S. economy is heating up. Job growth, retail spending, industrial output and even the housing market have all perked up.

What's not clear is whether it's just the warm weather we've been having or whether the economic fundamentals have improved.

This could see it as to be the first sign of a recovery [in housing] -- or as I see it, a blip.

November was about 2 degrees warmer than usual, while December was 4 degrees warmer and the warmest in 50 years. Temperatures remained mild in the most of the East for the first half of January as well.

The calendar says it's winter, but tell that to the cherry trees blooming in Washington and to the construction workers busy starting houses in New England.

The economy has certainly benefited from the warm weather. Energy prices have tumbled on reduced demand, freeing up cash for other purposes. Ground-breaking on new homes increased in November and December. Fewer workers are losing their jobs.

Some of the boost from the weather is real, but some of it is economic activity that's just been borrowed from the spring months. We probably won't know for several months how much it is real and how much of it is just people taking advantage of a few warm days to do now what they planned to do in March.

Whatever its cause, the burst of economic activity has lessened the pressure on the Federal Reserve to cut overnight interest rates to stimulate the economy. In essence, warm weather, falling gas prices and lower long-term interest rates have provided the stimulus many thought the Fed would have to provide.

In October and November, more than 80% of the economic data came in below expectations, but since the first of December, more than 50% of the data have been stronger than expected.

Changing rate expectations

The federal funds futures market now anticipates no rate cuts in the first half of the year and just one cut by the end of the year. For a brief moment, the market was even pricing in a 2% chance of a rate hike in March. By contrast, six weeks ago, the market was certain of one rate cut by July and was leaning toward three by the end of the year.
Those who've been forecasting that the next Fed move would be another rate increase are crowing.

Some will argue, of course, that warm weather was the main reason builders initiated more construction, as I do.

The discussion now is whether builders are (or are not) going to take on more construction loans, pay off contractors and put up new homes just because the weather has turned warmer.

"The worst for manufacturing may have passed last fall. With auto output stabilizing and firms related to housing presumably having made the bulk of the necessary adjustment to the slower pace of building, the manufacturing sector may be able to get back to modest growth in the months to come."... I don't know what you think, but I don't eat it.

Bears are sticking to their guns in the face of the stronger data, however.

I see the Fed cutting rates to 4% by the end of the year. I worry that an economic rebound now raises the risks of a harder landing later, as the Fed overreacts to higher inflation by raising rates, ignoring the bomb shell that's still ready to explode as weakness in the housing market saps the willingness and capacity of U.S. households to borrow.

Recession clouds darken 2007 outlook

Long time sine I wrote the last lines of my last article... consider it a X-mas break. Now we'r back on track, and this time is to write a little bit about U.S. slowdown and how it can turn into recession.

Most economists expect slower growth and no downturn, but some recent signals are flashing red.

The economy is stumbling at the end of 2006, setting off alarm bells that growth might not just slow next year but that the nation could tumble into a recession.

The recent trend of slower growth is not expected to be reversed any time soon. Home building and the broader real estate market are both already in a recession by most accounts and are expected to stay there well into next year. Manufacturing could soon follow.

While most traders are still expecting the economy to avoid a full-blown downturn next year, many of us say (at least) the odds of a recession have risen.

Even the more optimistic analysts are looking for a slowdown in growth in gross domestic product (GDP) to between 2 and 3 percent next year, from 3 percent or better this year.

Many don't think there'll be a recession, but at least you have to have to have in mind, as we do, that the risks have risen.

Some of the Christmas spending wasn't as strong as anyone'd hope, and I think we have not reached the bottom in housing yet.

With the yield curve in the shape it is now, the economy is more susceptible to shocks. For example, if oil went to $80 a barrel, or there was a sharp drop in the dollar, the U.S. could fall into recession, in my opinion with no chnce of recovery.

Not all declines in manufacturing lead to recession. But if the economy is going to go down, it's going to be led by manufacturing and construction.

On the other hand, others look at continued strength in consumer spending, even at the end of a year that saw record energy prices, coupled with low unemployment and rising exports and they say the chance of a recession next year is pretty slim.

So as I usually say, now it's your turn to look at this situation and think. You can always add some feedback to the article... hope you do!!

Till my next post.

Happy New Year and my best wishes.

Cheers to you all.