What is the “Bond Market”?
The bond market, which is the largest global securities market, is where supranational organizations, governments, banks and corporations (key issuers), and other types of issuers can borrow money from investors (i.e. raise debt). This can be done by issuing different types of debt securities with varying maturities in the primary market and where the same are traded in the secondary market. The purchasers of bonds can be governments, corporations, and individuals.
The third key player in the bond market is underwriters (investment banks and other financial institutions) who help an issuer to sell their bonds. Broadly speaking, though government bonds and corporate bonds are the largest segments of the bond market, there are others too – such as emerging market bonds, and mortgage backed and asset backed securities. Further, bonds can be broadly classified from the perspective of a country into three sub-categories – domestic, foreign, and Eurobond markets.
Key Learning Points
- The ‘Bond market’ refers to the trading (and issuing) of all debt securities from governments and corporations
- It can also be referred to as the credit market, debt market or fixed income market
- New bonds are issued on the ‘primary market’ and can then be traded between buyers and sellers on the ‘secondary’ market
- The two main segments of the US bond market are the US government and corporate bond markets
- There are bonds of varying maturities in the bond market and credit risk is inherent in all of them
- Credit rating agencies play a pivotal role in the bond market
- There are various types of yields quoted in the bond market
Bond Market – Salient Features
New bonds are issued on the primary market – the issuer sells the new debt directly to buyers. Once issued it can then be traded (facilitated by brokers) on the secondary market where the price can fluctuate depending on market conditions (such as interest and inflation rates) and also depending on the outlook for the issuing company or government.
The US is the largest bond market in the world (accounting for around 40% of the global bond market). The six main issuer categories in this market are: US treasuries (ranging from one month to 30 years (maturity), other US government bonds, corporate bonds, municipal bonds, foreign bonds and mortgage-backed securities.
The US government bond market is the largest and one of the most liquid. The types of US Treasury securities are Treasury bills, notes, and bonds. Further, there are the Treasury-Inflation Protected Securities (TIPS). The US is also the largest corporate bond market and the same can be categorized into four major types – commercial paper, investment grade bonds, high-yield bonds and leveraged loans.
The bond market offers bonds of varying maturities, ranging from short-term bonds, which mature over the next few years, intermediate-term bonds, which range between three to 10 years and long-term bonds, which mature in a period of more than 10 years, and generally up to 30 years.
Credit risk is inherent in all debt instruments. This risk entails the probability that a bond issuer may fail to make timely interest payments and repayment of principal i.e. default on its debt payment obligations. Other major types of risks that bonds in the bond market are subject to are: interest rate, inflation, real interest rate, liquidity, reinvestment, foreign exchange, call and sovereign risks.
Credit rating agencies such as Standard & Poor, Fitch Ratings and Moody’s, play a very important role in the efficient functioning of the bond market. Such agencies assess changes in default risk or the credit quality of a bond and assign a credit rating to it. Such a credit rating reflects the credit quality of the bond issue. A bond issue’s credit rating can be upgraded or downgraded.
There are various yields quoted in the bond market – current yield (this type of yield may or may not change depending on which type of bond is it: fixed rate, floating rate or indexed bonds), yield to maturity, yield to put, yield to call, yield to worst, tax-equivalent yield and cash flow yield.
Current Yield and YTM – Two Bond Yield Measures: Example
Given below are examples of two kinds of bond yields – current yield and yield to maturity (the most popular measure of yield in the bond market).
Current Yield = Annual Coupon Payment / Bond’s Current Market Price or Value
Based on the information below, the current yield (4.76%) has been calculated:
The Yield-to-Maturity (YTM) is the total rate of return on a bond if it is held until maturity. This assumes that all coupon and principal amounts are paid as per schedule and the investor is able to reinvest the coupon payments at the same yield.
Typically, the formula used to approximate the YTM of a bond is:
YTM (%) = C + (FV – PV/T) / (FV + PV/2)
C= Coupon or interest payment on the bond
FV = Face value of the bond
PV = Current price or value of the bond
T = Years to Maturity
Given below is the calculation of the Yield to Maturity (YTM) of a bond (6.3%) based on the information given. The frequency of coupon payments per year is annual i.e. once a year.