Lesson 9: The Bond Market

Lesson 9: The Bond Market

L9.2 Barry Bonds Pic
Still not the type of Bond I will discuss. Image courtesy of milwaukeechiro.com.

The bond market is much larger in dollar amount than the stock market in the United States. This is mainly driven by the ability for governments (including federal, state, and local) to participate in the bond market to raise capital.  This large market also produces Treasury bond interest rates (or yields), which are closely monitored proxies for long term interest rates.  In short the bond market lacks the glamour of the stock market due to its slower moving nature, but it still holds a place of great importance in the U.S. capital markets.

Key Points

  • Bonds have many commonalities with the stock market including primary vs. secondary markets, OTC markets vs. exchanges, and brokers vs. dealers.
  • The two primary issuers of bonds are governments and corporations.
  • Treasury bonds are arguably the most important type of bond traded.
  • Municipal bonds are bonds issued by local, county, and state governments that have favorable taxation characteristics.
  • Corporate bonds have different characteristics than federal bonds.

The Similarities between the Bond and Stock Market

Before we delve into what separates the two it would be easier to identity what the bond and stock markets have in common. Both the stock and bond markets have primary and secondary markets. A primary market is where securities are issued for the first time (when offered to the investing public this is called an initial public offering (IPO)) whereas the secondary market is where securities are traded between investors.  In addition bonds can be traded either in over-the-counter (OTC) or organized exchanges with brokers and dealers providing liquidity to these markets.

The Differences between the Bond and Stock Market

Other than the obvious differences between the nature of the securities being traded (there is a lot more knowns with bonds compared to L9.3 Featured Image for Bondsstocks) the largest difference is between the market participants.  While only private corporations participate in the stock market, both corporations and government entities may raise capital in the bond market. The reason governments do not participate in the stock market is that they would be selling ownership claims (imagine a super bank owning a small foreign government…yikes). Governments still have to fund different activities such as infrastructure, defense, and social programs and thus may turn to bond debt to finance these activities.  This is what is referred to when people quote the “$3 trillion deficit” America possesses, its bond debt.

The Importance of Treasury Bonds

The 10-year Treasury bond plays a key role in the U.S. financial markets.  It is one of the main ways the U.S. government funds federal expenditures.  They also have very little risk associated with them as in theory the U.S. government can always print more money to pay these bonds off as they come due.

Because of the low amount of risk these securities possess, little return is offered. In fact in some years the rate of inflation has been higher than the interest rate (or yield) offered on 10-year Treasury Bonds.  It also noted that the interest rate offered on 20-year Treasury Bonds is consistently higher than the interest rate offered on 10-year Treasury Bonds. The reason for this is simple and ubiquitous. The 20-year Treasury Bond has a longer maturity than the 10-year Treasury Bond and thus has more inherent risk and as our risk vs. return principal dictates the higher this possibility of risk the more compensation that must be offered to investors.  The U.S. federal government is of course not the only government that can sell bonds and at any given time you can buy French, Russian, or Argentinian bonds.  Depending on the riskiness of the country issuing, different returns are offered.  Similar to corporate bonds, bonds offered by governments are rated by rating agencies.

L9.1 Inflation vs. 10 Year Treasury Yield
Graph of 10-Yr U.S. Treasury Yield vs. Inflation Over Time

 

Municipal Bonds

Municipal bonds are bonds issued by local, state, or county governmental entities for the purpose of raising capital to fund public projects.  “Munis” have a small amount of default risk as a municipality can in fact default on its bonds. The two common types of municipal bonds are general obligation bonds and revenue bonds.  General obligation bonds are municipal bonds that do not have specific assets pledged as security for the bond and are instead supported by the “full faith and credit” of the issuer.  Bonds like this can also be referred to as unsecured bonds as there is no assets that serve as collateral for the bond.  A revenue bond is backed by the promised revenue of a project. An example of this would be charging fees to use a hospital or public port. These revenue streams provide funds to pay off the interest charges and principal of the outstanding bonds.  Revenues bonds can be referred to as secured bonds as there is an asset base supporting the repayment of the bonds.

One of the most important characteristics from an investor standpoint is that many municipalities place tax reductions or make the interest payments on the bond paid to the investor tax free, provided the investor is a resident of that municipality.  This is solely at the discretion of the issuing municipality, but for some high tax bracket investors muni’s present an opportunity to avoid large tax reductions from their investments.

Corporate Bonds

As a whole corporate bonds function similarly to government based bonds, but they have some differing characteristics. In general, corporate bonds pay a higher return than their government counterparts due to higher perceived risk of default on corporate. In the last lesson I discussed how the rating agencies rate the corporate bonds on the perceived risk of default the list of which I have provided again.  In addition corporate bonds are almost always issued in $1,000 par value, have the standard coupon payment structure, and may have a call provision which enables the issuing company to buy back (or “call”) the bond after a certain time period has elapsed.

Zero Coupon Bonds

A zero coupon bond is a type of bond that does not pay the investor interest payments but instead sells at a deep discount and is redeemed at maturity for a higher value.  In zero coupon bonds the investor forgoes the coupon payments in return for buying the bond at a discount and receiving a higher principal amount when the bond matures. For example you could buy a bond for $500 that in five years matures for $1,000 that offers no coupon payments. Many federal and municipal bonds function as zero coupon bonds.

Definitions

  1. Municipal bonds: Bonds issued by local, state, or county governmental entities for the purpose of raising capital to fund public projects.
  2. General obligation bonds: Unsecured municipal bonds that are backed by the “full faith and credit” of the issuing municipality.
  3. Revenue bonds: Municipal bonds that are secured by the revenue stream that will result from the completion and operation of the project the bond is funding.
  4. Call provision: A provision on bonds that enables the issuer to buy back bonds for a fixed payment that results in ceased interest payments to the investor who owns the bonds.
  5. Zero coupon bonds: Bonds that do not offer interest payments but are instead issued far below par and mature at par. The difference between the issuance price and the maturity is the yield the investor receives.

Further Reading

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