What Is the Bond Market?

Table of Contents

What Is the Bond Market?

Let me explain the bond market to you directly: it's the financial marketplace where governments and corporations issue and trade various debt securities to raise capital for their operations and growth. You might hear it called the debt market, fixed-income market, or credit market—it's all the same thing, covering all trades and issues of debt securities. Governments use bonds to raise money for paying off debts or funding infrastructure projects, while publicly traded companies issue them to finance expansions or keep operations running.

Key Takeaways

Here's what you need to know: Governments take the proceeds from bonds and put them toward infrastructural improvements or debt payments. Companies issue bonds to maintain their operations, grow product lines, or open new locations. Remember, bonds get issued on the primary market or traded on the secondary market, where you as an investor can buy existing debt through brokers or other third parties.

History of the Bond Markets

I want to take you through the history of bond markets, starting from ancient times. Loans that could be assigned or transferred appeared as early as ancient Mesopotamia, where debts in units of grain weight were exchanged among debtors. The recorded history goes back to 2400 B.C. with a clay tablet from Nippur in present-day Iraq, which guaranteed payment of grain and outlined consequences for non-repayment.

Moving to the Middle Ages, governments issued sovereign debt to fund wars. The Bank of England, the world's oldest central bank, was set up in the 17th century to raise money for rebuilding the British navy through bonds. In the U.S., the first Treasury bonds funded the military during the War of Independence and later as Liberty Bonds for World War I.

Early chartered corporations like the Dutch East India Company (VOC) and the Mississippi Company issued debt instruments before stocks. These were handwritten guarantees or sureties to bondholders, and the VOC was the first to widely issue bonds and shares to the public back in 1623.

Buying and Trading Bonds

You buy and trade bonds on the primary and secondary markets. The primary market is for new issues, where transactions happen directly between issuers and buyers—this is the primary distribution of brand-new debt securities not yet offered to the public.

On the secondary market, securities already sold in the primary market get bought and sold. You can purchase these through a broker acting as an intermediary. These secondary issues often get packaged into pension funds, mutual funds, or life insurance policies.

Types of Bonds

Let's break down the types of bonds you should know about. Starting with corporate bonds: Companies issue these to raise money for operations, expanding product lines, or new facilities. They're usually longer-term with maturities of at least a year, categorized by credit rating into investment-grade (high-quality, low default risk) and junk bonds (high-yield but higher risk of default). Rating firms like Standard & Poor’s and Moody's use letter designations to indicate quality.

Government bonds, or sovereign bonds, are issued nationally and pay out the face value at maturity with periodic interest, making them attractive to conservative investors as the least risky. In the U.S., these are Treasuries, the most active bond market. They include Treasury Bills (maturity one year or less), Treasury Notes (one to ten years), and Treasury Bonds (over 20 years). Note that in August 2023, Fitch downgraded the U.S. long-term rating to AA+ from AAA due to fiscal concerns and debt issues.

Municipal bonds, or munis, are issued locally by states, cities, and other entities to fund projects. They're often tax-free federally and sometimes at state levels, appealing to tax-conscious investors. Types include general obligation bonds (backed by taxes or general funds) and revenue bonds (secured by specific taxes or revenues).

Mortgage-backed bonds (MBS) are pooled mortgages on real estate, where you're essentially lending to homebuyers. They pay monthly interest but were central to the 2007-2010 subprime crisis due to failed mortgages.

Emerging market bonds come from developing economies, offering growth but higher risks like political volatility, exchange rate fluctuations, and devaluations. They gained traction with Brady bonds in the 1980s for debt restructuring.

Bond Indices

Just as stock indices track equities, bond indices like the Bloomberg Aggregate Bond Index, Merrill Lynch Domestic Master, and Citigroup U.S. Broad Investment-Grade Bond Index measure bond performance. The Agg is a market-weighted benchmark including government and corporate bonds with maturities over one year and issues above $300 million—it's a total return standard for many funds and ETFs.

Bond Market vs. Stock Market

Bonds are debt financing, while stocks are equity. Bond issuers must repay principal plus interest, unlike stocks which offer no guaranteed return. Bonds are less risky than stocks, with lower expected returns, but both markets are active and liquid. Bond prices move inversely to interest rates, while stock prices tie to future profitability.

Advantages and Disadvantages of Bonds

Experts recommend bonds in a diversified portfolio for their lower volatility than stocks, though they offer lower returns and carry credit and interest rate risks. They're less risky with a wide range of types, and bondholders get preference in bankruptcy. However, lower risk means lower returns, primary market access is limited, and there's exposure to defaults and rate changes.