What is the Bond Market?
Bond markets are a critical source of finance for many entities while offering investors a vast array of risk/reward profiles.
The global bond market is enormous – some commentators estimate the market to make up almost half of the world’s financial assets, double the size of the equity markets. Over time, the market has become progressively more sophisticated with new instrument variations/structures and a wider issuer profile.
What is a Bond?
A bond is a debt instrument that represents an amount of money borrowed by the issuer who commits to repay the same amount at an agreed date in the future.
Most, but not all, bonds pay the holder interest, known as a coupon, which may be fixed or floating.
A bond issue will consist of many identical bonds sold to investors and which have a standardized face value of, say, USD 1,000.
Bonds are typically negotiable instruments – ownership can be transferred from one party to another in the secondary market, which means that other investors can obtain the right to future bond cash flows.
A wide spectrum of issuers, ranging from governments to corporates, raise funds in the bond markets from a diverse investor base.
For these investors, the return from a bond must be appropriate to the level of risk.
Analyzing the risk of some borrowers, such as large sovereigns, may be relatively straightforward.
But this might not be the case for other borrowers such as foreign corporations or special purpose entities.
Specialist credit rating agencies take some of the legwork out of risk assessment but history has shown that investors cannot rely solely on these ratings.
Key Features of a Bond
There are a number of elements important to the makeup of a bond.
Coupon
Most bonds pay interest periodically – such as annually or semiannually – these payments are referred to as coupons.
Principal
A bond’s principal is the notional underlying amount that the issuer borrows and, in most cases, the amount to be repaid to the bondholder on the maturity date. The principal is also known as the par value, face value, nominal value/amount, or redemption value/amount.
Maturity
The majority of bonds have a set maturity or redemption date when the principal amount is repaid to the bondholder. The lifespan of a bond – term or tenor – can be any length of time, although debt securities of less than one year are generally classified as money market instruments. Some bonds may be repaid within a few years, while others have repayment dates decades into the future (for example, 30 years).
Price
Although a bond may have a face value of a particular amount (such as USD 1,000), prices are quoted as percentages. For instance, in the case of a USD 1,000 bond, a price of 101 would equate to 101% or USD 1,010.
Notes versus Bonds and Bills
In most fixed income markets in English-speaking jurisdictions, the terms “bonds” and “notes” are used interchangeably. One notable exception is the US Treasury market where bonds are instruments issued with an initial term to maturity of 30 years and all other fixed coupon instruments are referred to as “notes.”
What is Bond Yield?
The price an investor is willing to pay for a bond is equal to the evaluation of the present value of the future cash flows on the bond.
For a standard fixed rate bond, the most common method of such an evaluation involves calculating a price based on the rate of return (yield) which would be generated by buying the bond today and receiving the future cash flows. This return has two elements:
- Periodic coupon payments
- Any difference between the amount paid for the bond and the amount that will be received at redemption (that is, premium or discount)
In general:
- If a bond is bought at par value and held to maturity, then the return is equal to the coupon rate.
- If a bond is bought at a discount and held to maturity, then the return will be higher than the coupon rate.
- If a bond is bought at a premium and held to maturity, then the return will be lower than the coupon rate.
- In the case of a zero-coupon bond that repays at par, the return will be determined solely by the discount.
By calculating bond yields, investors can compare the rates of return available from bonds with differing coupon rates. Yield rather than price is used to determine whether a bond is “cheap” or “expensive.”
The market prices of bonds are usually expressed in terms of yield (which is then converted into an “invoice price” in the event of an actual transaction).
[Financial Markets 101: Different Types and What Shapes the Market]
The Importance of Liquidity
Bonds are specifically intended to be tradable. It is considered important by issuers that investors in their bond issues should have the confident expectation of being able to resell the bonds they purchase.
This requires an active secondary market, the presence of which improves the value of the bonds. Consider that a bond without any secondary market is less valuable than one where such a market exists.
The ability easily to transfer ownership is part of what distinguishes bonds from bank loans. Most, but not all, bank loans are bilateral contracts between the lender and the borrower and those remain the parties to the contract until the loan matures.
In the case of bonds, the original lenders who subscribe for the bonds can either hold the bonds to maturity if they wish, or they can sell the bonds to investors who may choose to buy them in the secondary market.
These investors may either be adding to positions they already have or opening positions in the bonds for the first time.
Bond Formats
Traditionally, bonds were evidenced tangibly in the form of paper certificates.
These paper certificates were elaborately printed as they were, in most cases, highly valuable.
Physical possession of these so-called “bearer” bonds was sufficient evidence of ownership and thereby conferred the right to sell them in the bond market or to retain them and ultimately claim repayment of the face value.
Most such bonds also had coupons attached to the main certificate which the holder would detach and surrender to the paying agent to claim the periodic interest payments.
The rapid expansion in IT has largely rendered bearer bonds obsolete.
Bearer bonds may have been necessary in the pre-electronic markets, but their disadvantages in terms of tax compliance, money laundering opportunities, and poor security against theft have seen traditional bearer bonds largely outlawed in most jurisdictions.
However, bearer bonds have not disappeared completely.
Today, many bond issues are evidenced by paper certificates but usually in the form of a global note which is a single certificate for the entire issue and which is deposited with a financial institution for safekeeping.
The issuance of definitive certificates to each investor is now very rare and, in most jurisdictions, illegal.
Bond Settlement
When a market participant buys or sells a bond the transaction is typically settled within one or two business days.
For example, US Treasuries are settled on the next good business day or T+1.
On the settlement date, there is a simultaneous transfer between the buyer and seller of the bonds.
This is referred to as delivery versus payment, or DVP.
DVP is a standard requirement in virtually all bond markets.
Bond Market Issuers and Investors
Bond market issuers vary markedly in terms of type and geographic location. The wide variety of potential debt instruments means that few borrowers are not involved in some way in the bond markets.
Bond investors can be divided into:
- Institutional investors
- Retail investors
Conclusion
In conclusion, bond markets are a critical source of finance for many entities while offering investors a vast array of risk/reward profiles.
There are several important aspects of this market, including the key features of a bond, bond yield, the importance of liquidity, bond formats, bond settlement, and bond market issuers and investors.
If you’re interested in learning more about bond markets and financial markets in general, Intuition Know-How offers a comprehensive digital learning course on the topic.
Below is a full list of tutorials from the suite of content:
- Financial Markets – An Introduction
- Money Markets – An Introduction
- Foreign Exchange (FX) Market – An Introduction
- Bond Markets – An Introduction
- Bond Markets – Issuing
- Bond Markets – Trading
- Equity Markets – An Introduction
- Equity Markets – Issuing
