Investing in the Bond Market, Part 1: The Basics


March 1  

This is part one of a series on the bond market.

The bond market is a decentralized market where debt can be bought, sold and issued. Unlike stocks, it can be more difficult to get information about individual bonds from the financial news media, but that doesn’t mean there isn’t plenty of money to be made in bonds. Let’s start with the basics of the bond market.

Bonds should be part of a wholistic investment strategy which includes other types of assets. The percentage of your portfolio that should be allocated to bonds will vary as you age. Because bonds are less risky than other assets, they tend to make up larger and larger percentages of investors’ portfolios as they age.

How the bond market works

Unlike the stock market, most bonds do not trade over an exchange. There is no trading floor or central location where all the trades occur. It is mostly an over-the-counter market, which means bonds are still traded over the phone, although at some point, we would expect computer-based bond trading to emerge. The part of the market where companies issue new bonds is called the primary market, while the area where buying and selling of bonds occurs is called the secondary market.

The bond market is actually part of the broader credit market. Bonds are basically a promise to pay back a loan on a particular date with interest paid at regular intervals until the due date. Those who issue bonds are obligated to make interest payments and pay back the loan by the due date, so they provide a steady stream of income for the investor up until the due date when they are paid off. Issuers may default on their bonds, but that usually only happens if they file for bankruptcy. Even in the case of a bankruptcy, bondholders can usually expect to receive some sort of payment from the issuer’s assets, if there are any available.  

In general, bond prices tend to be less volatile than stock prices, but that doesn’t mean bonds never whipsaw suddenly. Headline news can affect the value of bonds, especially those issued by companies rather then governments. Changes in the issuer’s credit rating can also affect bond valuations, although the bigger factor is interest rates, which have a sweeping effect on the market as a whole.

Inflation expectations also affect bond prices. Longer-term bonds like those which mature in 30 years rather than 10 usually have higher interest rates because inflation is expected to increase more over 30 years than over 10, and there is a greater risk associated with longer terms than shorter ones.. 

Because of the stability of the bond market, investors tend to flock to it when their appetite for risk declines. Bonds are generally considered safer because they are less volatile than stocks. Most bonds are held by institutional investors, mutual funds or banks. Only 10% of the bonds in the U.S. are held by private investors.

Interest rates and bond yields

Interest rates mark the foundation of the bond market, so whenever the U.S. Federal Reserve or another nation’s central bank adjusts interest rates, bond prices are affected. Bond prices move in the opposite direction of interest rates. When rates decline, the prices of already-existing bonds increases, and when rates increase prices fall.

The reason for this is simple. When interest rates fall, bonds that were issued before rates were cut are worth more than newly issued bonds because they earn more money. Investors would rather own bonds that were issued before interest rates were cut because they carry a higher interest rate and thus pay more than those that were issued after rates were cut. This creates more demand for older bonds and less demand for newer ones.

On the other hand, when interest rates are increased, investors would rather sell bonds that were issued before they increased and purchase new bonds issued under the higher interest rate because they pay more.

Aside from interest rates, there is one other factor that affects bond prices, which is yields. The yield is a bond’s annualized return, and it determines the coupon rate. The coupon rate is the time that’s left until the bond matures and is paid off. When a bond is first issued, the coupon rate and the yield are generally the same. However, if the price of the bond changes and a holder sells it, then the yield will change. An easy way to calculate the yield is to take the coupon amount divided by the price.

Types of bond issuers

Bonds are issued by several different types of entities. Government bonds are generally considered to be the most stable and safest. In the U.S., bond investors typically watch Treasury yields for signs of what to expect throughout the rest of the bond market. Treasuries basically remove one essential component of risk for investing in bonds, which is creditworthiness. The U.S. government is considered to be the most creditworthy of all types of issuers. Treasuries are considered to be a benchmark. As a general rule, when Treasury yields are on the rise, so are the yields on other bonds.

However, other governments may have varying levels of creditworthiness as estimated by their credit ratings. For example, the Venezuelan government is considered to be extremely high-risk, so its bonds would not be of interest for most investors.

Municipal bonds are issued by cities or other non-federal government entities. Some city governments may have better creditworthiness than others, depending on how their budget and balance sheet look. Local governments often issue municipal bonds to finance public infrastructure or other projects. The U.S. has the biggest market of tradeable municipal bonds in the world.

Corporate bonds are issued by companies. Companies issue corporate bonds if they need to finance some major expense or even ongoing operations if they are running at a loss. Other common reasons for issuing corporate bonds include mergers and acquisitions or business expansions. Maturities on corporate bonds are usually at least a year. Any corporate bonds with a maturity of less than a year is called commercial paper.

Types of bonds

Within corporate bonds are high grade or investment grade and high yield, which are also called junk bonds. The issuer’s credit rating is the key determiner of what grade is attached to its bonds. High grade bonds have a rating of AAA, AA, A or BBB, and anything rated BB or lower are considered to be high yield bonds. In other words, issuers with bad credit ratings offer high yield bonds. Investors in high yield bonds are taking on much more risk than investors in high grade bonds because the issuer’s credit rating is worse.

Corporate bonds can also be broken down into other different types based on the features they have. For example, investors who buy convertible bonds are allowed to convert them into equity. Bonds can also be unsecured or secured and subordinated or senior. Some corporate bonds also have embedded call or put options. Embedded call options are more common than embedded put options, and they allow the issuer to pay the debt off before it matures.

Risks of corporate bonds

One other concept that’s important for the bond market is the credit spread, which is the difference between the corporate bond’s yield and the yield of a government bond that’s of similar duration. The government bond used for the credit spread for bonds issued by U.S. companies is the U.S. Treasury.

Since the Treasury bond is considered an equivalent bond, except with little to no risk, the credit spread is the extra yield investors will earn over the risk-free equivalent. The extra yield is the reward investors receive for taking on the risk of a corporate bond instead of a government bond. Higher quality corporate bonds have a smaller credit spread than high yield bonds.

In addition to the risk of default, which we already mentioned, there are other risks associated with corporate bonds. One is the credit spread risk, which is the possibility that the bond’s credit spread will no longer be enough compensation for the risk of default. There is also a risk that interest rates will change and make the bonds less attractive. Since rates are locked in for the maturity of the bond, if the Fed changes the overall interest rate, bonds become more or less attractive.

Liquidity is also a potential risk for corporate bonds if investors can’t get rid of a bond they purchased. If the secondary market for the bond is healthy, then this isn’t a concern.   

The bond market is quite complicated, so it’s important to study all parts of it to get a better understanding of how things work and how to make a wise decision when it comes to buying or selling bonds. The rest of the articles in this series will break out each aspect of the bond market further and describe them all in additional detail.

About the Author

Trading and investing in markets is second nature to some, but a mystery to others. The goal is to provide a forum where everyday people aspiring to be part time or full time traders will learn how view markets differently and profit beyond their wildest dreams.

David Frost