How does the Bond Market Work

By: Brad Johnson | Views: 2941 | Date: 11-Mar-2011

A bond is simply a form of IOU where a purchaser gives the seller the right to use his or her money for a specified period of time in return for interest payments.

Stocks and bonds are often considered the most basic forms of investment. In fact "stocks and bonds" is a catch-phrase often applied to the idea of investment itself. In modern society almost 50% of households are involved in the stock market in some way, yet most people don’t really know what a bond is or how it works. While people know the investment world is full of "stocks and bonds" they are much more familiar with the "stock" component. This leads to the question, how does the bond market work?

What is a bond?

A bond is simply a form of IOU where a purchaser gives the seller the right to use his or her money for a specified period of time in return for interest payments. These numbers are defined in the terms of the bond, which include:
  • Face Value – The amount of the initial investment , or principle, in the bond.
  • Maturity Date – The date at which the buyers principle is repaid.
  • Coupon – The amount of interest to be paid on the bond.
  • Yield - Based on the coupon, this indicates how much the bond will pay per year.
Bonds can be issues by a variety of institutions. The most common issuers are corporations and governments. Government bonds are often issues by municipalities. These bonds, often referred to as "munis," are generally exempt from Federal income tax which gives them a considerable advantage.

The "bond market"

People often refer to the bond market, but this has a much less organized meaning than other kinds of markets. While equity markets like the stock, commodity and options markets deal with large amounts of identical instruments, very few bonds are ever alike. There are many shares of stock in the same class for a given company and no share is any different than any other so it is easy to make a market in them. Bonds however, have differing maturity dates and yields and are thus have lower liquidity.

Because of this most bond trades take place between very experienced investors. While many Americans take part in the stock market, very few own any bonds. These trades are often done between institutions in what are referred to as "over the counter" or OTC trades. Thus, small investors find a much harder time engaging in this kind of trading. Despite this some bonds are so prevalent that they are listed on exchanges. These are typically corporate bonds that were issued in large quantities.

One easy way for investors to get involved with bonds however is by using "bond funds." These are exchange traded funds that invest in bonds that meet particular criteria. The income from these bonds is paid out as a type of dividend. This can net an investor many of the benefits of bond ownership. These funds however are much more volatile because they are traded much more fluidly. Thus, unlike a bond you do not have any reason to necessarily feel you will get your principle back.

The "bond market" term

While there is no formal "bond market," you will hear the term quite frequently. This is usually used in the same ephemeral sense as the "stock market." When people refer to the "stock market" they are generally referring to the world of stocks as a whole. By the same token when the "bond market" is referenced they are often describing the asset class as a whole. So if the "bond market" is doing well this means bonds on average are doing well.

Another possible meaning of the "bond market" is the government bond market. Because the government deals in a massive amount of debt, its market is much more liquid than any corporate bonds. Thus oftentimes when someone is referring to the "bond market" they really are referring US government bonds.

Ultimately bonds are a tool that many investors’ kits lack. While they can be an important part of managing risks and returns, most people do not take the time and energy to learn about them. Now that you have learned the details of how the bond markets work, you can expand your knowledge and add this to your potential weapons.
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