Fundamentals in the Bond Market
Besides observing fundamentals and their place in stock market portfolio management, you can see how financial information works in the bond market. While bond market investors have a different approach than those in the stock market, they still need to observe a company's fundamentals as part of their decision making.
A bond investor is not interested in a company's growth potential. However, its capital strength and credit rating are of paramount importance, because bond investors want to be assured that the company will be able to repay the bond amount. A bond investor does not care about whether a company earns a profit, dominates its industry, or acquires other companies. The only immediate concern is the safety of the debt and the company's ability to repay.
In the bond market, it is not profit or profitability that matters, but credit rating. Standard & Poor's and other companies rate corporate debt according to the company's financial strength and ability to repay. Every company depending on debt financing wants the highest possible debt rating, because higher ratings translate to lower interest expense. That's because safer debt investments are more desirable. The highest Standard & Poor's long-term credit rating is AAA. This means that in the opinion of the rating company, the corporation has an extremely strong capacity to meet its obligations. Three other grades reflect gradually diminishing quality from AA (very strong) to A (strong) to BBB (adequate). The top four ratings are considered investment grade bonds.
When the rating service assigns a BB, B, CCC, CC, or С to bonds, they are considered to be increasingly speculative. Bonds in these classifications have been collectively referred to as junk bonds. One final classification worth noting assigned by Standard & Poor's is D, which means the company is in payment default.
Investors are also interested in the interest rate paid on a bond. Like stock market valuation, bond interest changes as the result of supply and demand. In the bond market, competition for finite debt investment capital exists not only among corporations, but also between corporate and government bond issuers. Bonds are issued to finance the national debt, states' debt and operations, and local governments and subdivisions as well.
Rate of return for bonds does not necessarily mean the nominal interest rate only (the stated annual rate of interest). For example, a bond with a nominal rate of 8 percent pays 8 percent of the par value of the bond. Par value, also called face value, is the amount that was originally issued and the amount that will be repaid. A bond is not always currently valued at par value, however. 
KEY POINT
Bond market value changes based on changing interest rates; bonds might be worth more or less than their par value.
The interest rate paid—the nominal interest rate—is fixed contractually for the life of the bond. However, there is no way to know whether that interest rate will be high or low relative to a current market rate in the future. This is a risk factor for bond investors. If a bond turns out to have a relatively high rate compared to future market rates, then its market value will move above market value, and it can be traded at a premium. If a bond turns out to have a relatively low rate compared to future market rates, then its market value moves below market rates. If sold, it commands a discounted value from its par value.
When a bond is valued above or below its par value, the current interest rate is different than the nominal interest rate because current market value of the bond has changed.
Example: A particular bond carries a nominal interest rate of 5 percent. However, the bond is currently trading at a discount of 97. To compute current rate, divide the nominal interest rate by the discount percentage. In this example, the current rate is 5.15 percent: 
Example: A bond carries a nominal rate of 5 percent. However, its market value is now at a premium of 102. Current rate is 4.90 percent: 
Premiums and discounts are the special features of concern to bond investors. Unlike shareholders who assume equity positions and are interested in the long-term growth prospects of their companies, bond investors are debtors. They compete with shareholders for profits.
Some portion of profits go to the payment of long-term bond interest, and the remainder is available to fund new expansion or to pay dividends. The greater the burden of interest paid to bondholders, the lower the earnings per share. Thus, bondholders and shareholders have an adversarial interest in their investment positions.
Bondholders have a contractual priority over common shareholders (but not over preferred shareholders). In the event of default, bond interest will be paid before dividends; and in the event of complete business failure, bonds are repaid before shareholders are provided any return. Thus, bondholders may have a degree of security in their position, but they will never realize the potential that long-term investors stand to have from selecting growth stocks.
The Options Market and Diversification
The relationship between fundamental analysis and risk raises the question How can you protect a profitable position or mitigate the threat of losses? In the long-term sense, the answer is that by selecting stocks based on a complete analysis of the fundamentals, such losses are mitigated drastically. In the short term, you can also use options to protect positions.
Options generally are considered to be high-risk investments. In the most popular ways they are used, they are high risk. However, two specific strategies can be used to reduce risk or to tie in profits, and should be considered as highly conservative strategies. KEY POINT
Buying options is highly speculative except when used as part of a stock investment strategy. Some option strategies are highly conservative.
Here is a brief overview of the options market. An option is an intangible right, a contract that provides its buyer with privileges in exchange for a purchase; specifically, the owner of an option has a right to buy or sell 100 shares of stock at a specified price, regardless of what the current market price is for that stock. A single stock option provides this right for 100 shares of stock.* Each option has specific attributes to it:
• The option is specific to one particular stock, called the underlying stock, and provides a right for 100 shares per option contract. Every option exists and pertains only to one specific company's stock, and is not interchangeable.
• A call option gives its owner the right to purchase 100 shares of stock. A put option gives its owner the right to sell 100 shares of stock.
• The option will expire in the near future. It exists only until the expiration date. After that date, the option is worthless.
• The option has a market value, called the premium. This premium rises and falls in accordance with the difference between current market value and the strike price, which is the price per share the option buyer has locked in.
There is a lot of terminology involved with the options market, which is unfortunate because it requires quite a learning curve just to grasp the concepts, learn the rules, and apply those rules to the question of managing your own risks. Options generally are highly speculative because they exist for only a short period of time. In order to make a profit as an option buyer, you depend on a significant movement in the stock's price, which will make the option more valuable. Time works against option buyers, and it is more likely that they will lose money than that they will make a profit.
The fundamentals of the option market are vastly different from those for stocks, because options are intangible. They exist as rights to take future action and do not hold any permanent value. So while an option's value is dependent entirely on near-term price changes in the stock, they lack any fundamental value except the current premium— based on supply and demand—and on the current price of the stock. KEY POINT
Buying options is highly speculative because they expire in the near future. Time works against the option buyer.
Options also are available for entire indexes, based on the New York Stock Exchange, Standard & Poor's indexes, the Value Line Index, and others. But for the purpose of explaining the use of options to reduce stock investment risk, the discussion here is limited to stock options.
For most moderate to conservative investors, buying options as speculative devices is far beyond the risk tolerance level. However, options can serve a purpose even in the most conservative portfolio. The two conservative strategies you can use in your portfolio provide a form of short-term insurance in situations where prices have risen dramatically. They can improve profits in situations where you would sell if you could get a specific price. They are (1) buying temporary portfolio insurance and (2) creating higher profits on sale. They are discussed below.
