The bond market is a financial market that has- a primary market in which governmental entities or corporations issue new debt securities – and – a secondary market in which investors buy and sell debt securities.
It is also known as the credit market, fixed income market, or debt market. It usually takes place with bonds. But it may also include bills and notes to meet the expenditure for public and private interest. The United States dominates the bond market. They have an approximate market of thirty-nine percent.
As per the Securities Industry and Financial Markets Association (SIFMA) report of 2021-
The worldwide size of the bond market (total debt outstanding) is around $119 trillion worldwide in which $46 trillion is for the US market.
This article will help you understand what a bond market is, how bond markets work and if bonds are a good and safe investment for you or not. So, let us get started-
What is the Bond Market?
Definition: The bond market is defined as a marketplace in which corporations or government issues debt securities that investors buy. Hence, it can also be described as a place where people purchase or sell debt securities.
The governments issue these bonds for raising the capital to pay for infrastructure development or provide finance to reduce the debts. While businesses issue bonds to channelize their business, set up in a new location, maintain continuity in the function, or optimize their products and services.
They issue bonds in a primary market condition for rolling out the latest debts or a secondary market condition for investors keen to buy the already existing debts. They do this through third parties or a broker. Bonds are comparatively more conservative than stocks. Bonds are is also less volatile but they offer lesser returns than stock.
How Bond Markets Work?
A government or corporation acts as a bond issuer and they issue bonds in the bond markets for raising the debt capital that can effectively fund the operations and channel growth. They also promise to the bond investors to repay the original investment amount along with the interest income.
Hence, a bond funds the different operations of a bond issuer, plus it also helps bond investors make money from their investments. As discussed above, bond markets are financial marketplaces that have two segments, the primary market, and the secondary market.
The primary market is where the direct purchase and sale occur between the issuer of the bonds and the buyers of the same. It cultivates the latest bond securities that have not been brought to the eyes of the general public before.
On the other hand, the secondary market involves reselling the bond securities already sold once in the primary marketplace. In this market condition, there is an involvement of brokers or middlemen.
They act as a bridge between the buyers and the sellers. They can sell the existing bonds to an investor after purchasing the same from the seller. These issues include mutual funds, life insurance policies, pension funds, and many more.
In bond markets, bond yields are the returns that investors get on a bond. Here, it is important to understand that bond prices and bond yields share an inverse relationship. So, when bond prices go up, the bond yields go down.
The level of prevailing interest rates is also one of the key factors that influence bond prices because when interest rates rise, bond markets notice a fall in the bond prices and vice versa.
Bond Markets History
The duration of bonds is more than the stocks. It dates back to the Mesopotamia era. Debts played a crucial role when it came to loans. It was divided into units of the weight of the grain. The exchange then took place between the debtors. The earliest debt instruments date back to 2400 B.C.
Sovereign debt followed the same in middle age. The government used it to provide funds for the wars. The British Navy received funds from the Bank of England, which is the oldest central bank. It issued funds with the help of issuing bonds. It was in the seventeenth century. The war for the independence of the British crown saw the issuance of the U.S. military treasury bonds. The second time it was known as the “Liberty Bonds.” It was introduced to raise funds for World War I.
In the same way, corporate bonds are also quite old. The issuance of the debt instruments came into existence before stock. It was introduced by the Dutch East India Company (VOC) and the Mississippi Company who were chartered corporations. The bonds were handwritten and were known as “sureties” and “guarantees.”
Types of Bond Markets
The bond market can be classified into the following types
1. Corporate Bonds
When companies issue bonds, they are understood as corporate bonds. Businesses or enterprises introduce corporate bonds for a variety of reasons. It includes the financing of the existing functions for continuity, expanding the line of products, introducing a new manufacturing facility, and many more. These bonds are for a prolonged time. The minimum span is one year.
These bonds are further classified into two categories, high yield (junk) and investment grade. It depends on the credit rating that the issuer and the bond receive. High-quality bonds refer to the investment grade. It has a lower risk of default. There are various techniques used for rating a bond and distinguish its quality. Standard & Poor’s and Moody’s are bond rating firms. They use upper and lower case letters to identify the qualities of the bonds.
On the other hand, junk bonds or high-yield bonds are those bonds that have a higher risk of default in comparison to those of the government and the corporations.
A bond is a promise made to the investors to pay interest payments. It comes along with the principal and is exchanged with the purchasing of the bond. Junk bonds that the companies issue is at high risk of defaulting. They struggle financially. These bonds usually receive very low ratings like BBB or Baa from the bond rating firms.
2. Government Bonds or Sovereign Bonds
These are the national-issued government bonds or sovereign bonds. These bonds have the face value encrypted on them. Also, the bond list contains the date of maturity of the same.
Here, people get their interests periodically paid. This way, the conservative investors get attracted to the government bonds. It is because the debts get a supporting hand from the government. Also, these debts are used to print money or citizen tax. It is believed that these bonds have the lowest risk.
The government bonds in the United States are known as Treasuries. It is the top bond market at present with most activities and liquidities.
3. Municipal Bonds or ‘Muni’ Bonds
These are bonds issued by the local heads like states, districts for a special purpose, cities, airports owned by the public, districts for public utility, and other entities that the government owns. They raise funds to provide finance for the completion of various projects.
These bonds are mostly exempted from tax. These bonds get the exemption from the local levels of tax and states as well. This way, it looks attractive to the investors who are conscious of tax. Municipal Bonds are distinguished into two different categories, a general obligation bond, and a revenue bond.
Government entities issue the general obligation bond that does not have revenue at the back from any given project. These bonds have the support of property taxes, and most of them are payable by general funds.
On the other hand, revenue bonds are those bonds that provide security to the principal and interest payments. It is applicable with the help of sales, issuer, fuel, occupying of a hotel, and other taxes. A third party helps in covering or financing the payment of principal and interest. It is mainly when the municipality is the issuer of the bonds.
4. Mortgage-Backed Bonds (MBS)
Mortgage-Backed bonds are those bonds that contain pooled mortgages. They also contain the promise of collateralized assets.
The people who purchase the mortgage-backed security lends money to the homebuyers via the lenders. The payments of the interests are made monthly, quarterly, and yearly. These bonds are asset-backed security or ABS.
5. Emerging Market Bonds
Market bonds that are emerging are issued by companies and governments situated in an emerging economy’s market. These bonds hold high opportunities. Also, a high-risk factor surrounds them when compared with the developed bond market or domestic bond market.
There is a risk in investing in emerging market bonds. It is the same as the risks associated with all the other bonds. It includes the performance of the finance, the economy of the issuer that is variable, and the capability of the issuer to pay the debt obligations. The volatility of the politics and economy of a country boosts the risk factor behind these bonds.
On the contrary, most of the emerging countries have handled the risk very skillfully. There are other risk factors attached to the emerging market bonds. It includes fluctuation of the exchange rates and devaluation of the currency.
The value of the currency directly or indirectly affects the yield when compared with dollars, mainly when the bond is issued in local currency. There is a positive impact on the yield when the local currency is heavy than the dollars. But it can turn otherwise if the dollar falls heavy on the local currency.
Difference between a bond market & a stock market
There is a vivid distinction that lies between a bond and a stock. Bond is referred to as financing the debts. On the other hand, stock refers to the financing of the equity. A bond is a type of credit that the issuer needs to repay along with the principal and the interest throughout the process.
On the other hand, the one who issues a stock may not have to repay the principal amount nor the interest. But a bond carries fewer risks than a stock. It is because of the protection from the legal authorities and the guarantee that comes along in a bond.
It has a statement that states the repayment of the debts to the creditors. Thus, bonds have lesser risk and have a typically low return than stocks. On the other hand, people can gain and loss a greater amount by investing in stocks.
The bond market and the stock market are very active and flexible. But the price of the bonds is more sensitive compared with the interest rate. The prices vary from time to time in an invertible way to the rate of interest. On the other hand, the price of the stocks is associated with the profit in the future and the growth that comes along.
1. The trading of Bonds
The traders who are associated with trading bonds are specialized in various types of bonds. It may include treasuries, corporate bonds, or municipal bonds.
A bond market does not provide a centralized exchange, unlike the stock market. The trading takes place between two individuals. Thus, there is no existence of great “bond tickers.”
There is a lack of visibility in the bond market. Thus, it is advisable to invest in the bond market via mutual funds or exchange-traded funds. It is safer than investing in individual bonds.
2. Bond Indices
Different bond indices like S&P 500, Bloomberg Barclays Aggregate Bond Index, Russell indices track equities, Merrill Lynch Domestic Master, Citigroup U.S. Broad Investment-Grade Bond Index are used for tracking and measuring the corporate bond portfolio performance.
Some of these bond indices are also involved with broader indices used for measuring the global bond portfolios’ performance.
Pros and cons of the Bond Markets
Financial experts believe that people who have diversification in their portfolios have some association with the bond market. Bonds carry lower risk with them.
They are more liquid and are diverse. Thus, it provides a low return when compared to stock. Also, there is a return of credit factor that comes with bonds. There are certain advantages and disadvantages of availing of a bond.
Bonds come with lower risk and have higher volatility. There is a wide range of issuers, and people can choose from the long list of bonds available. The corporation and government-issued bonds are the most liquid and active bonds in the market.
On the other hand, the disadvantage of availing of a bond is a low return rate which comes with the low-risk factor. There is a lower chance of accessibility of buying a bond directly from the investor. Purchasing a bond may expose you to the repayment of the principal amount along with the interest rate risk.
A bond market is a credit market and contains a lower risk percentage. It comes with legal guarantees and protections. Thus, people can avail of it for better safety purposes. But it is also necessary to know that availing of a bond may come with a lower return and a risk of changes in the rate of interest.
A bond market is larger than a stock market. Also, it is volatile and more liquid. It is an active marketplace. It is usually a creditor that lends money to a lender. In turn, the lender needs to repay the principal capital along with interest.
A bond market has various segments. These segments are further classified into different domains. Thus, people can have a wide range of options to choose from. On the contrary, a stock market is narrower. Apart from that, bond markets are in existence for a longer period as compared to stock markets.
Now, after understanding the whole concept of different types of bonds, how would you define a bond market?