When you hear someone talk about “the market,” it’s not uncommon to immediately think of the stock market. But, in reality, the stock market (there are actually several “stock” markets) is just one of many different kinds of financial markets.
Other types include derivatives markets and commodities markets. One of the most important markets for both individual and institutional investors is the bond market.
What is the bond market?
The bond market, broadly speaking, is a term used to refer collectively to any activity related to the buying, selling, and trading of bonds. Because of their unique characteristics, high-quality bonds are often a core component of retirement accounts, pensions, and investment portfolios.
According to the Securities Industry and Financial Markets Association (SIFMA), the United States bond market currently consists of $52.9 trillion worth of outstanding bonds as of April 2022. The global bond market, by comparison, is estimated by the International Capital Market Association (ICMA) to be roughly $128.3 trillion in size.
How do bonds work?
A bond is essentially a loan that you make to a borrower — typically the federal government, a government agency, a municipality or a corporation. In this scenario, the investor becomes a bondholder, while the recipient of the funds becomes the bond issuer. Bonds are also often called debt securities or debt instruments.
In exchange for your investment, you receive regular interest payments from the bond issuer (known as coupon payments). How much interest depends on the bond’s coupon rate, which is established at the time that the bond is issued. The period of time that the loan is in effect is called the term. When it reaches the end of the term it is referred to as when the bond matures. At that point, the bondholder can cash it in, at which point they can expect to receive back their initial investment. This is also known as the bond’s face value.
Of course, sometimes you may decide that you don’t want to hold a bond until it reaches maturity. In cases like these, you can turn to the bond market in order to sell your bond to others.
Types of Bonds
There are four primary types of bonds: Government bonds, agency bonds, municipal bonds, and corporate bonds. Each type of bond has its own pros and cons:
- Government bonds: Government bonds are offered by the U.S. federal government. They include Treasury bills, Treasury notes, Treasury bonds, Treasury Inflation-Protected Securities (TIPS), and I-Bonds. Because these bonds come with the full backing of the United States Treasury, they are considered some of the least risky bonds. For that reason, they also tend to carry lower interest rates compared to other types of bonds.
- Agency bonds: Agency bonds are issued by federal government agencies, but not directly by the U.S. Treasury. These bonds can be less liquid than Treasury bonds — meaning they’re harder to sell — and tend to carry slightly higher interest rates than Treasuries. They are still considered some of the least risky bonds available.
- Municipal bonds: Municipal bonds are offered by individual municipalities, such as states, cities, and counties. Usually, municipal bonds are issued to raise capital to fund a specific project, such as the construction of a bridge or school. Municipal bonds are considered riskier than Treasury and agency bonds.
- Corporate bonds: Finally, corporate bonds are those issued by a company. Corporate bonds are typically considered to be riskier than the other types of bonds discussed above, because they are tied to the fates of individual companies which may or may not struggle to meet their obligations to bondholders. This increased risk often translates into increased yield. Generally speaking, the more established the company, the stronger its credit rating, and the longer its credit history, the less risky it will be considered.
How does the bond market work?
The bond market facilitates two key activities. First, it is through the bond market that governments, municipalities, agencies, and corporations issue most new debt in the form of bonds, which can be purchased by investors. Second, the bond market provides a venue for bondholders to sell or trade their bonds with other investors if they do not wish to hold the bond until it matures.
Technically, these activities take place in two different markets: The primary bond market and the secondary bond market.
Primary vs Secondary Bond Markets
New bonds are issued through the primary bond market. This means that in the primary bond market, transactions take place directly between the bond’s issuer (such as the federal government or agency, municipality, or corporation) and investors, who ultimately become bondholders. For this reason, the primary bond market is also sometimes called the new issues market.
In the secondary bond market, the bond’s issuer is no longer involved. Instead, the secondary market is where bondholders can sell their bonds to other investors. Bondholders who do not wish to hold their bonds until maturity will often turn to the secondary market to liquidate their holdings. Typically, these transactions go through a broker.
On the secondary market, it’s important to note that bond prices can be influenced by a number of factors. One of the most important factors is the Federal Funds Rate, which influences interest rates.
Generally speaking, interest rates and the price of existing bonds move in opposite directions. When interest rates rise, the price of existing bonds on the secondary market will fall. That’s because rising interest rates mean that newly issued bonds will offer investors a higher yield than existing bonds. Meanwhile, the opposite is also true. Falling interest rates tend to push the price of bonds on the secondary market higher. While bond prices do rise and fall, it’s important to point out that because of the way bonds work, as they approach maturity bonds will return to their original price (known as par). That’s because when a bond matures, the issuer is expected to pay the bond holder the face value of the bond.
Pros and Cons of the Bond Market
There are many reasons that you might choose to invest in bonds. On the one hand, bonds can be an excellent option for investors looking for income generation, and can help improve a portfolio’s diversification. Likewise, high-quality bonds are generally considered to be a more stable, less volatile, and less risky investment than stocks and many other assets. On the other hand, this reduced risk typically translates into reduced reward as well.
While bonds are considered to be less risky than stocks, they are not risk free. If the bond issuer defaults, it’s possible you will lose your principal. Additionally, as discussed above, bond prices on the secondary market can fluctuate when interest rates rise and fall.
Investing in the Bond Market
Whether or not you choose to incorporate bonds in your investment portfolio, as well as how much of your portfolio you allocate to bonds, will depend on a number of different factors. This includes your individual risk tolerance, your investment horizon, and your personal financial goals.
When it comes to actually investing in bonds, you’ve got a few options. If you’d like more control over the composition of your bond portfolio, you might choose to invest in individual bonds. Of course, if you go this route, it’s essential to ensure that you properly vet each bond before investing and diversify your holdings.
Alternatively, you can invest in one or multiple bond funds. Because bond funds invest in a variety of bonds, this option would immediately diversify your bond holdings. Of course, it’s important to consider any fees charged by the funds that you select.
If you’re unsure about the role that bonds can play in your financial plan, how much of your portfolio you should allocate to bonds, or the specific steps you should take to build a bond portfolio, working with a financial advisor can help.
All investments carry some level of risk including the potential loss of principal invested. Diversification and strategic asset allocation do not assure profit or protect against loss.
You should carefully consider risks with fixed income securities such as bonds, these include: Interest rate, Duration, Credit, Default, Liquidity and Inflation. Interest rates and bond prices tend to move in opposite directions, for example when interest rates fall, bond prices typically rise. This also holds true for bond mutual funds. A low interest rate environment may cause losses to bond prices and bond funds you own or in the market. High yield (Junk) bonds and bond funds that invest in high yield bonds present greater credit risk than investment grade bonds.