The Bond Market and Debt Securities: An Overview

When companies or other entities need to raise money to finance new projects, maintain ongoing operations, or refinance existing debts, they may issue bonds directly to investors. The borrower (issuer) issues a bond that includes the terms of the loan, interest payments that will be made, and the time at which the loaned funds (bond principal) must be paid back (maturity date). The interest payment (the coupon) is part of the return that bondholders earn for loaning their funds to the issuer. The interest rate that determines the payment is called the coupon rate. U.S. government bonds are typically considered the safest investment. Bonds issued by state and local governments are generally considered the next-safest, followed by corporate bonds.

Retirees often invest a larger portion of their assets in bonds in order to establish a reliable income supplement. To illustrate these concepts in the classroom, I’ve often held a bond auction in class! I offer to pay $1.00 on the last day of class, and ask what students will offer for it. Other times they sit for a moment in shock, too stunned to participate—but if I joke “You mean no one will even buy my bond for even a penny?! We talk about risk and how my not honoring my debt would get me in trouble as a teacher, which increases what students are willing to pay for my bond. Occasionally during the semester the buyer even sells the bond to another student, illustrating a secondary bond market in action.

  1. Treasury bonds 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 raise funds to fight World War I.
  2. The lower a bond’s ratings, the more interest an issuer has to pay investors in order to entice them to make an investment and offset higher risk.
  3. The amount it is worth is determined primarily by the number of payments that still are due before the bond matures.
  4. Most bonds issued by companies include options that can increase or decrease their value and can make comparisons difficult for non-professionals.

In the first answer I used governments as an example, but it is not all governments nor is it only governments. A downside is that the government loses the option to reduce its bond liabilities by inflating its domestic currency.

Up to this point, we’ve discussed bonds as if every investor holds them to maturity. It’s true that if you do this, you’re guaranteed to get your principal back plus interest; however, a bond does not have to be held to maturity. At any time, a bondholder can sell their bonds in the open market, where the price can fluctuate, sometimes dramatically.

Bond Market and Interest Rates

Most bonds can be sold by the initial bondholder to other investors after they have been issued. In other words, a bond investor does not have to hold a bond all the way through to its maturity date. It is also common for bonds to be repurchased by the borrower if interest rates decline, or if the borrower’s credit has improved, and it can reissue new bonds at a lower cost. Bond details include the end date when the principal of the loan is due to be paid to the bond owner and usually include the terms for variable or fixed interest payments made by the borrower. Investors may also gain access to corporate bonds by investing in any number of bond-focused mutual funds or ETFs.

The investor then gets to receive a stream of future payments. We can also measure the anticipated changes in bond prices given a change in interest rates with a measure known as the duration of a bond. Duration is expressed in units of the number of years since it originally referred to zero-coupon bonds, whose duration is its maturity. Bonds provide a solution by allowing many individual investors to assume the role of the lender.

U.S. Treasury bonds

In general, experts advise that as individuals get older or approach retirement, they should shift their portfolio weights more towards bonds. Bonds are a type of security sold by governments and corporations, as a way of raising money from investors. From the seller’s perspective, selling bonds is therefore a way of borrowing money. From the buyer’s perspective, buying bonds is a form of investment because it entitles the purchaser to guaranteed repayment of principal as well as a stream of interest payments. Some types of bonds also offer other benefits, such as the ability to convert the bond into shares in the issuing company’s stock.

Types of Bond Risk

We call this second, more practical definition the modified duration of a bond. Bond prices in the market react inversely to changes in interest rates. Similarly, corporations will often borrow to grow their business, to buy property and equipment, to undertake profitable projects, bonds definition economics for research and development, or to hire employees. The problem that large organizations run into is that they typically need far more money than the average bank can provide. The interest rate is the amount of the interest expressed as a percentage of the principal.

You may not realize it, but you buy and sell bonds all the time! Every time you lend someone a few dollars for lunch or borrow your friend’s car in exchange for filling her tank, in economic terms you are buying and selling bonds. Bonds are priced in the secondary market based on their face value, or par. Bonds that are priced above par—higher than face value—are said to trade at a premium, while bonds that are priced below their face value—below par—trade at a discount. Like any other asset, bond prices depend on supply and demand.

Yield to maturity is considered a long-term bond yield but is expressed as an annual rate. In other words, it is the internal rate of return of an investment in a bond if the investor holds the bond until maturity and if all payments are made as scheduled. Zero-coupon bonds (Z-bonds) do not pay coupon payments and instead are issued at a discount to their par value that will generate a return once the bondholder is paid the full face value when the bond matures.

A puttable bond usually trades at a higher value than a bond without a put option but with the same credit rating, maturity, and coupon rate because it is more valuable to the bondholders. Bonds that are not considered investment grade but are not in default are called “high yield” or “junk” bonds. These bonds have a higher risk of default in the future and investors demand a higher coupon payment to compensate them for that risk. Bonds issued by local governments or states are called municipal bonds. They come with a greater risk than federal government bonds but offer a higher yield.

Callable bonds may be redeemed by the company before the maturity date is reached, typically at a premium. It can be beneficial for a business operating in an environment where interest rates are decreasing because the firm can reissue bonds with a lower yield. When the stock market is doing well, investors are less interested in purchasing bonds, so their value drops.

These four bond types also feature differing tax treatments, which is a key consideration for bond investors. Bonds work by paying back a regular amount to the investor, also known as a “coupon rate,” and are thus referred to as a type of fixed-income security. For example, a $10,000 bond with a 10-year maturity date and a coupon rate of 5% would pay $500 a year for a decade, after which the original $10,000 face value of the bond is paid back to the investor. Governments and companies in emerging market economies issue bonds that provide growth opportunities but with greater risk than domestic or developed bond markets. Treasury Secretary Nicholas Brady began a program to help global economies restructure their debt via bond issues denominated in U.S. dollars.

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