The Bond Market (aka Debt Market): Everything You Need to Know

What Is the Bond Market?

The bond market—often called the debt market, fixed-income market, or credit market—is the collective name given to all trades and issues of debt securities. Governments typically issue bonds in order to raise capital to pay down debts or fund infrastructural improvements.

Publicly traded companies issue bonds when they need to finance business expansion projects or maintain ongoing operations.

Key Takeaways

  • The bond market broadly describes a marketplace where investors buy debt securities that are brought to the market by either governmental entities or corporations.
  • National governments generally use the proceeds from bonds to finance infrastructural improvements and pay down debts.
  • Companies issue bonds to raise the capital needed to maintain operations, grow their product lines, or open new locations.
  • Bonds are either issued on the primary market, which rolls out new debt, or traded on the secondary market, in which investors may purchase existing debt via brokers or other third parties.
  • Bonds tend to be less volatile and more conservative than stock investments, but they also have lower expected returns.
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Understanding Bond Markets

The bond market is broadly segmented into two different silos: the primary market and the secondary market. The primary market is frequently referred to as the "new issues" market in which transactions strictly occur directly between the bond issuers and the bond buyers. In essence, the primary market yields the creation of brand-new debt securities that have not previously been offered to the public.

In the secondary market, securities that have already been sold in the primary market are then bought and sold at later dates. Investors can purchase these bonds from a broker, who acts as an intermediary between the buying and selling parties. These secondary market issues may be packaged in the form of pension funds, mutual funds, and life insurance policies—among many other product structures.

Bond investors should be mindful of the fact that junk bonds, while offering the highest returns, present the greatest risks of default.

History of Bond Markets

Bonds have been traded far longer than stocks have. In fact, loans that were assignable or transferrable to others appeared as early as ancient Mesopotamia, where debts denominated in units of grain weight could be exchanged among debtors. In fact, the recorded history of debt instruments dates back to 2400 B.C.⁠—via a clay tablet discovered at Nippur, now present-day Iraq. This artifact records a guarantee for payment of grain and listed consequences if the debt was not repaid.

Later, in the middle ages, governments began issuing sovereign debts in order to fund wars. In fact, the Bank of England, the world's oldest central bank still in existence, was established to raise money to rebuild the British navy in the 17th century through the issuance of bonds. The first U.S. Treasury bonds, too, were issued to help fund the military, first in the war of independence from the British crown, and again in the form of "Liberty Bonds" to help raise funds to fight World War I.

The corporate bond market is also quite old. Early chartered corporations such as the Dutch East India Company (VOC) and the Mississippi Company issued debt instruments before they issued stocks. These bonds, such as the one in the image below, were issued as "guarantees" or "sureties" and were hand-written to the bondholder.

A bond from the Dutch East India Company (VOC), dating from Nov. 7, 1623. The VOC was the first company in history to widely issue bonds and shares of stock to the general public.
A bond from the Dutch East India Company (VOC), dating from Nov. 7, 1623. The VOC was the first company in history to widely issue bonds and shares of stock to the general public.

Types of Bond Markets

The general bond market can be segmented into the following bond classifications, each with its own set of attributes.

Corporate Bonds

Companies issue corporate bonds to raise money for a sundry of reasons, such as financing current operations, expanding product lines, or opening up new manufacturing facilities. Corporate bonds usually describe longer-term debt instruments that provide a maturity of at least one year.

Corporate bonds are typically classified as either investment-grade or else high-yield (or "junk"). This categorization is based on the credit rating assigned to the bond and its issuer. An investment-grade rating signifies a high-quality bond that presents a relatively low risk of defaultBond-rating firms like Standard & Poor’s and Moody's use different designations, consisting of the upper- and lower-case letters "A" and "B," to identify a bond's credit quality rating.

Junk bonds are bonds that carry a higher risk of default than most bonds issued by corporations and governments. A bond is a debt or promise to pay investors interest payments along with the return of invested principal in exchange for buying the bond. Junk bonds represent bonds issued by companies that are financially struggling and have a high risk of defaulting, or not paying their interest payments or repaying the principal to investors. Junk bonds are also called high-yield bonds since the higher yield is needed to help offset any risk of default. These bonds have credit ratings below BBB- from S&P or below Baa3 from Moody's.

Government Bonds

National-issued government bonds (or sovereign bonds) entice buyers by paying out the face value listed on the bond certificate, on the agreed maturity date, while also issuing periodic interest payments along the way. This characteristic makes government bonds attractive to conservative investors. Because sovereign debt is backed by a government that can tax its citizens or print money to cover the payments, these are considered the least risky type of bonds, in general.

In the U.S., government bonds are known as Treasuries and are by far the most active and liquid bond market today. A Treasury Bill (T-Bill) is a short-term U.S. government debt obligation backed by the Treasury Department with a maturity of one year or less. A Treasury note (T-note) is a marketable U.S. government debt security with a fixed interest rate and a maturity between one and 10 years. Treasury bonds (T-bonds) are government debt securities issued by the U.S. Federal government that have maturities greater than 20 years.

Municipal Bonds

Municipal bonds—commonly abbreviated as "muni" bonds—are locally issued by states, cities, special-purpose districts, public utility districts, school districts, publicly owned airports and seaports, and other government-owned entities that seek to raise cash to fund various projects.

Municipal bonds are commonly tax-free at the federal level and can be tax-exempt at state or local tax levels too, making them attractive to qualified tax-conscious investors.

Munis come in two main types. A general obligation bond (GO bond) is issued by governmental entities and not backed by revenue from a specific project, such as a toll road. Some GO bonds are backed by dedicated property taxes; others are payable from general funds. A revenue bond instead secures principal and interest payments through the issuer or sales, fuel, hotel occupancy, or other taxes. When a municipality is a conduit issuer of bonds, a third party covers interest and principal payments.

Mortgage-Backed Bonds (MBS)

Mortgage-backed security (MBS) issues, which consist of pooled mortgages on real estate properties, are locked in by the pledge of particular collateralized assets. The investor who buys a mortgage-backed security is essentially lending money to homebuyers through their lenders. These typically pay monthly interest.

The MBS is a type of asset-backed security (ABS). As became glaringly obvious in the subprime mortgage meltdown of 2007-2010, a mortgage-backed security is only as sound as the mortgages that back it up.

Emerging Market Bonds

These are bonds issued by governments and companies located in emerging market economies, providing much greater growth opportunities, but also greater risk, than domestic or developed bond markets.

Throughout most of the 20th century, countries with emerging economies issued bonds only intermittently. In the 1980s, however, then-Treasury Secretary Nicholas Brady began a program to help global economies restructure their debt via bond issues, mostly denominated in U.S. dollars. Many countries in Latin America issued these so-called Brady bonds throughout the next two decades, marking an upswing in the issuance of emerging market debt. Today, bonds are issued in developing nations and by corporations located in these countries all over the world, including from Asia, Latin America, Eastern Europe, Africa, and the Middle East.

The risks of investing in emerging market bonds include the standard risks that accompany all debt issues, such as the variables of the issuer's economic or financial performance and the ability of the issuer to meet payment obligations. These risks are heightened, however, due to the potential political and economic volatility of developing nations. Although emerging countries, overall, have taken great strides in limiting country risks or sovereign risk, it is undeniable that the chance of socioeconomic instability is more considerable in these nations than in developed countries, particularly the U.S.

Emerging markets also pose other cross-border risks, including exchange rate fluctuations and currency devaluations. If a bond is issued in a local currency, the rate of the dollar versus that currency can positively or negatively affect your yield. When that local currency is strong compared to the dollar, your returns will be positively affected, while a weak local currency adversely affects the exchange rate and negatively affects the yield.

Bond Indices

Just as the S&P 500 and the Russell indices track equities, big-name bond indices like the Bloomberg Aggregate Bond Index, the Merrill Lynch Domestic Master, and the Citigroup U.S. Broad Investment-Grade Bond Index track and measure corporate bond portfolio performance. Many bond indices are members of broader indices that measure the performances of global bond portfolios.

The Bloomberg (formerly Lehman Brothers) Government/Corporate Bond Index, also known as the 'Agg', is an important market-weighted benchmark index. Like other benchmark indexes, it provides investors with a standard against which they can evaluate the performance of a fund or security. As the name implies, this index includes both government and corporate bonds. The index consists of investment-grade corporate debt instruments with issues higher than $100 million and maturities of one year or more. The Agg is a total return benchmark index for many bond funds and exchange-traded funds (ETFs).

Courtesy Bloomberg
Courtesy Bloomberg.


Bond Market vs. Stock Market

Bonds differ from stocks in several ways. Bonds represent debt financing, while stocks equity financing. Bonds are a form of credit whereby the borrower (i.e. bond issuer) must repay the bond owner's principal plus additional interest along the way. Stocks do not entitle the shareholder to any return of capital, nor must they pay interest (or dividends). Because of the legal protections and guarantees in a bond stating repayment to creditors, bonds are typically less risky than stocks and therefore command lower expected returns than stocks. Stocks are inherently riskier than bonds and so have a greater potential for bigger gains or bigger losses.

Both stock and bond markets tend to be very active and liquid. Bond prices, however, tend to be very sensitive to interest rate changes, with their prices varying inversely to interest rate moves. Stock prices, on the other hand, are more sensitive to changes in future profitability and growth potential.

For investors without access directly to bond markets, you can still get access to bonds through bond-focused mutual funds and ETFs.

Advantages and Disadvantages of the Bond Market

Most financial experts recommend that a well-diversified portfolio have some allocation to the bond market. Bonds are diverse, liquid, and less volatile than stocks, but they also provide generally lower returns over time and carry credit and interest rate risk. Therefore, owning too many bonds can be overly conservative over long time horizons.

Like anything in life, and especially in finance, bonds have both pros and cons:

Pros
  • Tend to be less risky and less volatile than stocks.

  • Wide universe of issuers and bond types to choose from.

  • The corporate and government bond markets are among the most liquid and active in the world.

  • Bondholders have preference over shareholders in the event of bankruptcy.

Cons
  • Lower risk translates to lower return, on average.

  • Buying bonds directly may be less accessible for ordinary investors.

  • Exposure to both credit (default) risk as well as interest rate risk.

What Is the Bond Market and How Does It Work?

The bond market refers broadly to the buying and selling of various debt instruments issued by a variety of entities. Corporations and governments issue bonds to raise debt capital to fund operations or seek growth opportunities. In return, they promise to repay the original investment amount, plus interest. The mechanics of buying and selling bonds works similarly to that of stocks or any other marketable asset, whereby bids are matched with offers.

Are Bonds a Good Investment?

Like any investment, the expected return of a bond must be weighed against its riskiness. The riskier the issuer, the higher the yield investors will demand. Junk bonds, therefore, pay higher interest rates but are also at greater risk of default. U.S. Treasuries pay very low interest rates but have virtually zero risk.

Are Bonds a Safe Investment?

Bonds tend to be stable, lower-risk investments that provide the opportunity both for interest income and price appreciation. It is recommended that a diversified portfolio have some allocation to bonds, with more weight to bonds as one's time horizon shortens.

Can You Lose Money in the Bond Market?

Yes. While not as risky as stocks on average, bond prices do fluctuate and can go down. If interest rates rise, for example, the price of even a highly rated bond will decrease. The sensitivity of a bond's price to interest rate changes is known as its duration. A bond will also lose significant value if its issuer defaults or goes bankrupt, meaning it can no longer repay in full the initial investment nor the interest owed.

The Bottom Line

The bond market is among the largest asset markets in the world⁠—almost twice as large in terms of notional value as the stock market. The bond market includes debt securities issued by governments and corporations, both domestic and foreign. Bonds may also be structured with fixed or variable interest rates and may or may not be convertible into equity. Bonds are typically thought to be less volatile than stocks, since they pay regular interest and return principal upon maturity. However, the bond market can lose value, and credit risk exists. Most financial professionals advise that all investors contribute at least some portion of their portfolios to bonds to help diversify.

Article Sources
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