The Bond Market: Its Structure and Function

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Checklist Description
This checklist describes the bond market and outlines its structure and function. Back to top

Definition
The bond market is the market for debt securities in the form of bonds where buyers and sellers determine their prices and therefore their accompanying interest rates. It is also known as the fixed-income or debit or credit market. In purchasing a bond you are effectively lending money to a government, corporation, or municipality, known as the issuer, which agrees to pay you a certain rate of interest during the lifetime of the bond and repay its principal or face value when it matures or becomes due. The international bond market is estimated to have a size of almost US$47 trillion. The US bond market is the largest in the world, with an outstanding debt of more than US$25 trillion. In 2007, the volume of trade in the US bond market was US$923 billion. Since 2000, the international bond market has doubled in size as a result of the activity of big multinational companies. According to the International Capital Market Association, about US$10 trillion worth of bonds were outstanding in 2007. The individual government bond markets have a high level of liquidity and considerable size these are included in the international bond market. They are noted for their low credit risk and are unaffected by interest rates. Trading generally takes place over the counter (known as OTC) between broker dealers and big institutions. The stock exchanges list a small number of bonds too. The largest centralized bond market is the New York Stock Exchange (NYSE), which mainly represents corporate bonds. In contrast to this, most governments have bond markets that lack

centralization, mostly due to the fact that bond issues vary widely and there is a large choice of different securities by comparison. Most outstanding bonds are in the hands of institutions: pension funds, mutual funds, and banks. This is because individual bond issues are so specific and a large number of smaller issues lack liquidity. The volatility of the bond market is in direct proportion to the monetary and economic policy of the country of the participant. The main difference between corporate and government bonds is that the latter are guaranteed and thus carry a low risk of investment, albeit at a lower rate of return. Corporate bonds generally offer a higher rate of return on investment, but carry more riskif the company fails, the bondholder risks losing their investment. Back to top

Advantages

It is considered a wise move to invest in bonds as part of a considered diversified investment portfolio that also consists of stocks and cash. They are considered to be a relatively safe investment for increasing capital and receiving a reliable interest income. The principal and interest are set at the time the bond is purchased. If the owner collects the coupon and holds it to maturity, the market is irrelevant to final payout. As a longterm investment, bonds may be considered a wise choicebearing in mind the disadvantages.

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Disadvantages

Bonds are not advisable for short-term savings for the individual participant in the market. Long-term commitment is essential as the participant who cashes in before maturity is open to the risk of fluctuations in interest rates. Whenever there is an increase in interest rates, there is a corresponding decrease in the value of existing bonds. Conversely, a decrease in interest rates will correspond to a rise in the value of existing bonds. This is due to the fact that new issues pay out a lower yield. The basic concept of bond market volatility is that the value of bonds and changes in interest rates run inversely to each other. When interest rates drop, investors have to reinvest their interest income and return of principal at lower rates. The final purchasing power of an investment in bonds is reduced by a corresponding increase in inflation, which also results in higher interest rates and correspondingly lower bond prices.

If there is a decline in the bond market as a whole, individual securities also fall in value. Timing is crucial: a security may in the future unexpectedly underperform relative to the market. A bond may perform poorly after purchase, or it may improve after you sell it. Corporate bonds have relatively low liquidity compared with government bonds, which usually have a short lock-in period (i.e. they can be cashed in quickly).