The Bond Market and Debt Securities: An Overview

What Is the Bond Market?

The bond market is often referred to as the debt market, fixed-income market, or credit market. It is the collective name given to all trades and issues of debt securities. Governments issue bonds to raise capital to pay debts or fund infrastructural improvements. Publicly traded companies issue bonds to finance business expansion projects or maintain ongoing operations.

History of the Bond Markets

Loans that were assignable or transferrable to others appeared as early as ancient Mesopotamia, where debts denominated in units of grain weight could be exchanged among debtors. The recorded history of debt instruments dates back to 2400 B.C.⁠ via a clay tablet discovered at Nippur, now present-day Iraq. This artifact cites a guarantee for payment of grain and the consequences if the debt was not repaid.

In the middle ages, governments issued sovereign debt to fund wars. The Bank of England, the world's oldest central bank, was established to raise money to rebuild the British navy in the 17th century through bonds. The first U.S. Treasury bonds were issued to help fund the military, first in the war of independence from the British crown, and again in the form of "Liberty Bonds" to raise funds to fight World War I.

Early chartered corporations such as the Dutch East India Company (VOC) and the Mississippi Company issued debt instruments before they issued stocks. These bonds, such as in the image above, were "guarantees" or "sureties" and were hand-written to the bondholder.

Buying and Trading Bonds

Bonds are traded on the primary market and the secondary market. The primary market is the "new issues" market, and transactions occur directly between the bond issuers and the bond buyers. This offering is known as the primary distribution. The primary market holds brand-new debt securities not previously offered to the public.

In the secondary market, securities previously sold in the primary market are bought and sold. Investors can purchase these bonds from a broker, who acts as an intermediary between the buying and selling parties. These secondary market issues may be packaged as pension funds, mutual funds, and life insurance policies.

Types of Bonds

Corporate Bonds

Companies issue corporate bonds to raise money for current operations, expanding product lines, or opening up new manufacturing facilities. Corporate bonds are commonly longer-term debt instruments with a maturity of at least one year and are commonly categorized into two types based on the credit rating assigned to the bond and its issuer.

Investment grade signifies a high-quality bond that presents a relatively low risk of default. Bond-rating firms like Standard & Poor’s and Moody's use different designations, consisting of the upper- and lower-case letters "A" and "B," to identify a bond's credit quality rating.

Junk bonds or high-yield bonds carry a higher risk. Junk bonds represent bonds issued by companies that are financially struggling and have a high risk of defaulting, not paying their interest payments, or repaying the principal to investors. Junk bonds are also called high-yield bonds since the higher yield is needed to help offset any risk of default.

Government Bonds

Nationally-issued government bonds or sovereign bonds entice buyers by paying out the face value listed on the bond certificate on the agreed maturity date with periodic interest payments. This makes government bonds attractive to conservative investors and considered the least risky. In the U.S., government bonds are known as Treasuries and the most active and liquid bond market.

• Treasury Bill (T-Bill): a short-term U.S. government debt obligation backed by the Treasury Department with a maturity of one year or less
• Treasury note (T-note): a marketable U.S. government debt security with a fixed interest rate and a maturity between one and ten years
• Treasury bonds (T-bonds): government debt securities issued by the U.S. Federal government with maturities greater than 20 years

Municipal Bonds

Municipal bonds or "muni" bonds are locally issued by states, cities, special-purpose districts, public utility districts, school districts, publicly owned airports and seaports, and other government-owned entities that seek to raise cash to fund various projects. Municipal bonds are commonly tax-free at the federal level and can be tax-exempt at state or local tax levels, making them attractive to qualified tax-conscious investors.

A general obligation bond (GO bond) is issued by government entities not backed by revenue from a specific project. Some GO bonds are backed by property taxes or payable from general funds. A revenue bond secures principal and interest payments through sales, fuel, hotel occupancy, or other taxes. When a municipality is a conduit issuer of bonds, a third party covers interest and principal payments.

Mortgage-Backed Bonds (MBS)

Mortgage-backed security (MBS) issues consist of pooled mortgages on real estate properties. The investor who buys a mortgage-backed security is essentially lending money to homebuyers through their lenders. These typically pay monthly interest.

The MBS is a type of asset-backed security (ABS). During the subprime mortgage meltdown of 2007-2010, this type of security relied on failed mortgages to support it.

Emerging Market Bonds

Governments and companies in emerging market economies issue bonds that provide growth opportunities but with greater risk than domestic or developed bond markets. In the 1980s, U.S. Treasury Secretary Nicholas Brady began a program to help global economies restructure their debt via bond issues denominated in U.S. dollars.

Many countries in Latin America issued these Brady bonds throughout the next two decades, marking an upswing in the issuance of emerging market debt. Bonds are issued in developing nations and by corporations in Asia, Latin America, Eastern Europe, Africa, and the Middle East.

Investing in emerging market bonds includes the standard risks that accompany all debt issues, such as the variables of the issuer's economic or financial performance and the ability of the issuer to meet payment obligations. These risks can be heightened by the political and economic volatility in developing nations. Emerging market risks also include exchange rate fluctuations and currency devaluations.

Bond Indices

Just as the S&P 500 and the Russell indices track equities, bond indices like the Bloomberg Aggregate Bond Index, the Merrill Lynch Domestic Master, and the Citigroup U.S. Broad Investment-Grade Bond Index track and measure corporate bond portfolio performance.

The Bloomberg U.S. Aggregate Bond Index, the 'Agg,' is a market-weighted benchmark index. It provides investors with a standard against which they can evaluate a fund or security. The index includes government and corporate bonds and investment-grade corporate debt instruments with issues higher than $300 million and maturities of one year or more. The Agg is a total return benchmark index for many bond funds and exchange-traded funds (ETFs).

Bond Market vs. Stock Market

Bonds represent debt financing, while stocks are equity financing. Bonds are a form of credit where the bond issuer must repay the bond owner's principal plus additional interest. Stocks do not entitle the shareholder to any return of capital.

Because of their legal protections and guarantees, bonds are typically less risky than stocks and command lower expected returns than stocks. Stocks are inherently riskier than bonds and have the potential for bigger gains or bigger losses.

Both stock and bond markets tend to be very active and liquid. Bond prices tend to be sensitive to interest rate changes, varying inversely to interest rate moves. Stock prices are sensitive to changes in future profitability and growth potential.

Advantages and Disadvantages of Bonds

Financial experts commonly recommend a well-diversified portfolio with some allocation to the bond market. Bonds can be less volatile than stocks with lower returns and carry credit and interest rate risk. Owning too many bonds is considered overly conservative over long time horizons.

The Bottom Line

The bond market includes debt securities issued by governments and corporations, both domestic and foreign. Bonds may also be structured with fixed or variable interest rates and may or may not be convertible into equity. Bonds are typically thought to be less volatile than stocks since they pay regular interest and return principal upon maturity.