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How the Bond Market Works

January 10, 2012

The term bond is used to describe a wide variety of securities traded on US and other markets. A bond itself is essentially a loan, in which the buyer loans money to the issuer. The difference is that the buyer has the right to sell if the bond if he or she wants. There are many different kinds of bonds around all of which trade much like stocks or commodities.

The bond market is highly complex and unlike the stock, currencies or commodities market is not widely traded in by average people. Instead most bond trades are performed by professionals on behalf of large institutional investors. An exception to this is the Treasury bond market where a large amount of average people participate.

Bond Market Classifications

The major bond market classifications are: US Treasury (bonds issued by the federal government), corporate bonds or corporate paper (bonds issued by big business), high-yield or non-investment grade or “junk” bonds (bonds in risky businesses such as startups), mortgage backed securities (bonds backed by mortgages), asset-backed securities (paper backed by some sort of individual or corporate debt usually auto loans or credit cards), agency bonds (securities issued by corporations backed by the federal government such as Fannie Mae), municipal bonds (securities issued by state or local governments) and collateralized debt obligations or CDOs (another kind of bond backed by debt).

Each of these kinds of bond trades on its own market. Generally an issuer creates a security and releases it on the market where it thinks it raise the most money. A number of different mechanisms are then used to determine the bond’s price and value. These include yield to maturity which is the amount of income bond can generate through interest.

How Ratings Affect the Bond Market

The bond’s rating also affects its value. The big three ratings agencies (Moody’s, Standard & Poor’s, Fitch’s) evaluate bond issuers to determine how likely they are to default. The securities are given grades such as CCC or AAA, a top rated bond would be AAA while a low rated one would be CCC.

The greater the capability that an issuer has to meet its obligations the higher the rating the bond gets. Higher-rated bonds generally have a higher price and a lower interest rate. Lower rated securities such as junk bonds and CDOs pay a much higher interest rate but they are more risky.

Generally government issued bonds such as US Treasuries are the highest rated. Municipal bonds can run the gamut from junk bonds to highly rated ones. When you’ve heard that a ratings agency has downgraded a company or government it has given that entity’s bonds a lower rating. Lowering the rating increases the cost of borrowing money but it can make the paper a more attractive investment because it has a higher return.

Benchmarking of Bonds

The common method of determining bond value and risk is called benchmarking. In this practice an expert compares an issue with a highly rated security or benchmark. An analyst might compare Smallville Sewer District Bonds with US Treasury bonds to see how safe they are. The more characteristics Smallville’s issuing shares with US Treasury notes the better it will be ranked.

The Bond Market and You

The average person should confine his or her bond investment to diversified bond funds and to US Treasury Bondss. This market is simply too complex and fraught with peril for the average person to risk his or her money. Everyday there are stories about people who lost everything investing in asset backed securities or CDOs. Yes bonds are very secure and you should put part of your portfolio in them but you must keep your exposure to the bond market limited.

Steven Hart is a freelance writer and a Financial Advisor from Cary, IL. He writes about Annuity topics like Ordinary Annuity, Retirement Annuity, and Income Annuity.


From → Investing

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