What is a Bond Market?

bond investment 101

An Introduction to Fixed Income Investment

A bond market, also known as a fixed income market, is a financial investment market where participants buy and sell debt securities.

As of 2008, the total international bond market was believed to be worth $67 trillion. Of that, the American bond market is thought to have a total net worth of $33.5 trillion.

References to the term “bond market” usually refer to government bond markets. This is generally the case because of their size and liquidity, as well as their lack of credit risk. Additionally, due to the inverse relationship between bond valuation and interest rates, bond markets are sometimes used as an indicator of sudden changes in interest rates.

Bond Market Structure

In most countries, bond markets are decentralized. The reason for this is because, unlike stock exchanges or futures markets, no two bonds are exactly alike. One of the consequences of this decentralized market structure is that trading in bonds can incur higher costs at the expense of less liquidity in some cases.

In their 2004 paper, Secondary Trading Costs in the Municipal Bond Market, Lawrence Harriss and Michael Piwowar concluded that, “municipal bonds are substantially more expensive than similar sized equity trades.” They argued that this difference in price is a result of the lack of transparency in the bond market.

Types of Bonds

Bond markets are divided into a number of sub categories, depending on what type of bond is being traded.

Bond Investors

Similarly, investors who use bond markets can also be divided into a number of sub-categories.

  • Institutional investors
  • Governments
  • Bond traders
  • Private investors

Because of the lack of liquidity in the bond market, private investors only make up a small portion of the bond market in the United States.

The Global Bond Market

In 2008, the size of the global bond market increased to $83 trillion. Of that amount, 71% consisted of domestic markets. In the United States, a quarter of the market was composed of mortgage-backed bonds. In Europe, bond prices have been significantly affected by public debt, where government spending is set to increase for the foreseeable future.

Bond Market Instability

One of the advantages of bonds over other types of market investment is that they are not subject to the same volatility as stocks or currency exchanges. Principle and interest is delivered according to a set schedule.

However, participants who buy and sell bonds before they reach maturity run a number of risks, including sudden changes in interest rates. High interest rates can depress bond prices, while low interest rates can inflate them. This is an example of how bond markets can be affected by a country’s over all economic policy.

Bond markets can also be affected by the interpretation of economic indicators. If the consensus reached by economists is uniform, there may be very little movement. However, if there is no consensus, bond prices may be significantly affected as investors attempt to interpret the data on their own. This is also compounded by the fact that the importance of economic indicators can vary depending on the stage of the business cycle.

Tracking Bond Performance

There are a number of bond indices, which exist for the purpose of managing and tracking bond portfolios. Some of the better known bond indices include the Barclays Aggregate, the Citigroup Broad Grade Investment Index and the Merrill Lynch Domestic Master.

Their long-term stability and lack of credit risk make bond markets a popular choice for cautious investors.

Monthly Income from Bond Funds: Investors Have a Variety of Choices to Receive that Monthly Check

Monthly Income from Bond Funds

Investors Have a Variety of Choices to Receive that Monthly Check

Bond funds offer an alternative for the less affluent investor but income can vary depending on the credit risk taken and where on the yield curve money is placed.

For the affluent investor, putting a portfolio together to provide monthly income is not so much of a problem. People of more modest means still have the ability to provide that monthly income from bond funds. It is nevertheless important for the investor to realize the relationship between risk and return as the choices among bonds funds are quite wide and reflect that risk in the returns they provide.

Interest Rate Is a Statement of Risk – Period

To quote an age-old cliché, there is no such thing as a free lunch. If there is one simple concept that investors must realize about bonds or the fixed-income market, it is that interest rate is statement of risk. We know that risk can take many forms; market or yield curve, credit, foreign exchange and so forth. With that in mind, let’s take a look at what is available.

Money Market Funds

Money market funds are comprised of very short term debt instruments. Most of these instruments are very credit worthy and have little principal risk. While considered to be very safe from a principal risk perspective, the reinvestment risk is substantial and thus unpredictable and undependable.

Mutual Funds

The good news regarding mutual funds is that they are managed by professional asset managers. The bad news is that most mutual funds, regardless of the type of bonds in them, are also “open-ended.” What that means in practical terms is that as more money comes into the fund, it is invested at prevailing interest rates, whether those rates are higher or lower. This means that returns can vary constantly.

Unit Trusts

Unit Trusts, although related to mutual funds, are quite different. Regardless of the notes and bonds chosen by the professional managers, they never change. The notes and/or bonds in the trust may be sovereign debt, corporate debt or perhaps collateralized hybrid securities.

The maturities are also different, coming in intermediate and/or longer term maturities. The major attraction of Unit Trusts is they usually pay a monthly check.

The choices are very wide both in terms of quality and maturity for the investor. Quality and risk are of course commensurate with return like anything else. Investors should be aware of the sovereign, credit and maturity risk before making a decision.

Costs and Fees

Another factor that investors should be aware of are the costs and fees associated with these products. Mutual funds can vary widely in terms of costs. Some are “no-load” or fee while others do have a “load” or sales charge. That fee can also depend on the amount of money invested. Read the fine print – some mutual funds charge a “management fee” in addition to the sales charge.

Unit Trusts are most always sold on a “net” basis. In other words, the dealer’s fee is built into the price, which the investor never sees. This fee is often 2% to 3% of the principal amount. A rule of thumb, the longer the maturity, the larger the fee. There is rarely if ever an on-going management fee however.

The bottom line for investors is to determine beforehand not only the risks involved but how much of their money is actually going to work for them.

Par, Interest, Yield, Maturity

Many people get confused witht the numerous bond products available. This article attempts to simplify this process into easy language for all to understand.

Bonds, put simply, are instruments of debt. When a government, municipality or company needs money they try to raise it by getting investors to lend it to them. In return for this privelage, they promise to repay the entire debt back to us on a specified date. Interest payments will be made bi-annually, at a specified interest rate. Although this is simple enough, there are certain things that a savvy bond investor needs to know before jumping into the bond market.

Most bonds are offered through brokers in brokerage firms. There is a vast array to choose from, but regardless of the type, all can be analyzed in the same way.

Par

Par refers to the price of an individual bond. The price of the bond depends upon current interest rates. A bond offering 5% interest, at a time when new bonds are being offered at a rate of 4%, will experience more demand due to the higher interest rate. As a result the price or par will be higher. If a bond is offering only 3% interest and the interest rates on new bonds is being offered at 4%, then you can expect a bond to be offered below par.

Each par price represents one bond. One bond represents $1000 worth. So if you see that the par for a bond is listed as 100.00, that means the cost of 1 bond will be exactly $1000. If the par is listed at 103.45, the cost of 1 bond will be $1035.45. If you want 50 bonds at 103.45, which represents $50000 worth, you will be paying $51725.00. It is important to note that although you’re paying more for the bond, the actual value of this bond if held to maturity will be only $50,000.

The extra cost is due to the higher interest rate being offered in comparison to other comprable bonds. If par, on the other hand is listed at 97.00, then the cost for 1 bond of $1,000, will be only $970. If the bond is held to maturity, you will get back the actual value of the bond which is $1,000. In this scenario, you have made $30 from the time of purchase to the time of maturity.

Interest

5% interest on a $10,000-dollar investment, will mean we’ll get $500 interest a year, payable in 2 installments of $250, every 6 months. The months you get paid can be figured out based on the maturity date of the bond. If the bond becomes mature in June, then interest will be payed both in June and December, which is 6 months later.

When purchasing bonds, look at the yield listed for the bond, instead of income. Although the amount of income is something you have to determine for yourself, there still will be different prices for bonds that seem to be offering the same interest rate. There are many reasons for this, usually due to demand for that specific bond type.

Yield

Yield is what your bond is actually costing you. Yield is a calculation of all of your interest payments over time plus the actual cost of the bond. You may notice that some bonds, with a higher par, will actually yield you more.

That’s because you will get more income from this bond over time than you would with another, even though its initial costs are higher. The rule of thumb should be buy a bond with the highest yield that you can afford at the rate you want. Certainly don’t overpay. Decide what it is you want to spend and see what’s available.

See the Wall Street Journal’s Lifetime Guide To Money for more information.

Tips on Buying Bonds in the US

Standard & Poor/Moddy’s Rating Systems, Accrued Interest & Insurance

To buy a bond intelligently you’ll need to understand Standard & Poor/Moody’s Rating Systems, accrued Interest and insured bonds as well as other factors related to cost.

Before proceeding into the bond market you’ll need to know bond rating systems, such as that of Standard and Poor’s or Moody’s rating systems, accrued interest, maturity dates call dates, and insured bonds. Rating systems are vital to any bond for they relate to you how creditworthy the issuing entity is in terms of being able to repay the loan or bond back to you.

Any one of the two mentioned above are accurate in the way they rate. You will find that bonds are rated by both or by either one. When rated by both you’ll rarely see any differences in their ratings for the same bond. Bonds are rated as AAA or AA+ which denotes the highest rating that one could give to an issuing entitiy, downwards to CCC or less.

Bonds in this lower spectrum are speculative, usually refered to as junk bonds. These issuing entities are either near bankruptcy or are nearly insolvent. In general stay away from bonds rated below A.

Accrued Interest

Accrued interest refers to the interest that is accumulating on a bond that hasn’t been purchased yet. When you buy a bond, not only do you pay the par price for it, but you’ll need to purchase the accumulated interest on that bond as well.

This interest, although purchased, will get refunded back to you on your next interest payment date plus any additional interest that accumulates from the time you purchase the bond.

As an example, you buy 10 bonds of ABC at 100 par giving 5% interest. The ABC bond gives interest in March and September. You buy this bond in December. So, for arguments sake, you will pay $10,000 for the 10 bonds, plus $125 for the accrued interest that has accumulated since its last interest due date back in September. So the total cost to you is $10125.

When the next interest payment date arrives in March you’ll get not only the $125 dollars that you paid in December, but an additional $125 that you made holding the bond from December to March, for a total of $250. Interest gets paid twice a year. 5% of $10000 is $500 per year dividied by 2 semiannual payments of $250 per payment.

Maturity and Call Dates

The maturity date tells you the latest date the bond needs to be payed back. Bonds, depending on their type, can range from a month to upwards of 30 years. The longer the bond takes to mature, the riskier the bond will be, due to it being subject to varying interest rates.

Call dates give the issuing entity an option to pay the bond back earlier. This is important because if an issuer decides to pay the loan back sooner, it can affect your overall yield. Usually a call to yield rate is listed with each bond. This allows you to see what the differences are with this yield in relation to the yield to maturity number.

You must factor this in to your decision-making process when buying bonds, so as not to overpay for a bond that could potentially give you less in the long run, compared to other comprable products.

All call dates have a par number written. Sometimes issuers will compensate you for the “inconvenience” of a call, so to speak. This means that ABC has the right to pay back the loan entirely instead of its maturity date.

However, they will pay $10200 for every $10000 you hold, giving you more than face value. In general, if interest rates go below what you are currently recieving by way of bond interest, expect a company to call the bond. If interest rates are higher than what you are recieving, it’s a safe bet that the company will want to keep the lower interest rates and not call the bond.

Guaranteed Payment

Bonds, in general, aren’t insured. Usually insured bonds are seen in the municipal bond market. Although no municipality has actually defaulted on its bonds, some have come close. As a result, many have insured themselves in case of default, promoting a sense of confidence in the investing public. It’s OK to invest in these, but by sticking to AAA or AA rated bonds, you’ll still come out fine.

Types of US Bonds

A discussion of the various bond types

There are many bonds available for investment. We will discuss these briefly in this section.

Bonds are issued by various entities. This article will concentrate on the bonds available in the US. The most common entities in todays market are the Federal Government, states, municipalities and various business entities. All have advantages, some drawbacks. The following paragraph will discuss these in general. Investing in bonds is a way of preserving your capital. It will not fluctuate as wildly as the stock market does, but remember that in terms of capital appreciation, it will not keep up with inflation and the cost of living either.

From the US Government

The safest bond anyone can invest in are US Treasury Bonds, Notes or Bills. All three are similar. The terminology has to do more with maturity time and amount needed to purchase the bond.

Treasury bills or T-bills need a minimum of $10000 for an investment to be made. T-bills usually are short maturity bonds that will mature within a year. Treasury notes and bonds are of longer duration and can be purchased in $1000 increments. These bonds are the safest because of the implied condition that the US government will print money, if necessary, to cover its debts.

The advantages of this are obvious. Any entity that can print money will not default on its loans. They are always AAA rated. The interest you recieve is state tax exempt, but are federally taxaxable. The only disadvantage is that you pay a bit more for the safety of the bond and wil recieve a little less interest than what is currently being offered in the bond markets.

Other US Government Products

Other federal bonds available are Freddie Macs, Ginnie Maes and Farm Credits. They are a form of assistance for housing and mortgages that are offered to the general public. The difference between these and the treasuries is that they aren’t backed by the same money printing implication as the others.

However, considering the effect that a US government default on its bonds would have in the world, the chances of this happening are very slim indeed. Most are AAA rated. They give considerably more interest than treasuries, for almost the same safety. They are federally taxable and some are state taxable, while others are state tax exempt. You’d need to consult your brokerage firm as to which ones are taxable or tax-exempt.

Municipal Bonds

Municipal bonds, are bonds issued by states and municipalities. Some are insured, while others aren’t. They aren’t as safe as government bonds, because states can’t print money. However, if you stick to insured bonds or bonds rated AA or higher, there are other advantages that these bonds offer.

To purchase these bonds you’ll need an ivestment of $5000 or higher since they are sold in $5000 increments. Municipal bonds are federally tax exempt and are state tax exempt if the municipality of the bond you bought is the same as the one you live in. If you purchase an out of state municipal bond, then they will be only state taxable and still federally tax exempt. Municipal bonds are good for those in higher tax brackets, who need to get income, yet don’t want to increase their tax burden. They are relatively more expensive that other bonds.

Corporate Earnings

Corporate bonds are issued by companies. Although least safe of all, they do issue higher interest rates than the others types of bonds available. Interest is fully taxable and the bonds are non-insured. SInce companies can go bankrupt, you’ll need to stay with bonds rated AA or AAA.

Pool Your Money

Finally, there is another way to buy bonds. If you don’t have a lot to invest and buying individual bonds is out of the question, then consider buying bond mutual funds. Depending on the company running the fund, you can purchase these for a fraction of the cost of a single bond. There are literally hundreds of bond funds available, in all the different types of bonds mentioned above.

The advantage is that you can actually invest in riskier bonds and get higher interest. Since the funds carry thousands of bonds, one or two defaults will not affect the overall portfolio. On the other hand, your bond shares will fluctuate with the times. You aren’t buying them face value, as you would individual bonds. Funds will continuously buy and sell bonds based on values posted daily.

If they can make a profit they’ll sell them and go and invest elsewhere. If the bonds go down in value, so will the shares of your fund. So when it comes time to redeem your bond fund shares, realize that the price per share may be more or less than what you paid.

Although this subject is extensive reading bookswill further your knowledge. Stick to the above and do not wander into unsafe investment vehicles. Bond trading, a subject onto itself, should be left to the pros. There are many ways to invest in bonds. Pick the one best suitable for you.