Back to the Basics: Interpreting the Bond Market

By Cindy Ivanac-Lillig

Investors generally have two choices in the financial market. They can purchase a piece of a company by buying what’s called a stock, or they can lend money to a company, city, state, or country by buying a bond. Under the most basic bond structure, you buy a bond, and the bond issuer pays you interest at agreed-upon intervals. And at the maturity date, the issuer pays you back the principal. Bonds are also often referred to as fixed income investments because of these regular interest payments. (By the way, there are also other types of debt investments that are securitized pools of debt with similar features, such as mortgage-backed securities, but I will leave those aside for now for the sake of simplicity.)

It’s interesting to note that more than half of the bonds out there are not government ones, but rather corporate bonds. That means many large multi-national corporations find better financing options by selling bonds than by going to a bank to ask for a loan. In addition, keep in mind that bonds are not available to everyone. Many bond investors are what the industry calls institutional investors. These are typically financial firms that buy bonds as investment vehicles for pension plans, mutual funds, etc. Many of us, in fact, are bond investors through our mutual funds, pensions, and 401K accounts. However, we can’t go out on our own and buy a bond issued by, say, a large Mexican oil company.

Another important point to keep in mind is that the bond market is much larger than the equity market. The global equity market is somewhere in the neighborhood of $25-55 trillion, depending on the source. Since the recession, the figures have tended to be on the lower end of this range. The bond market, in contrast, is somewhere in the range of $80-95 trillion. And unlike the equity market, the bond market is more obscure, less developed and more closely traded.

So, why spend this much time discussing the bond market? Well, I have had many conversations with my Italophile friends regarding the bond market and I realized that it may be helpful to revisit some of the basics as we digest the latest headlines. I do believe the Italian bond market will be judged based on the country’s economic fundamentals, its ability to grow, its ability to service its debt, etc. However, I also believe that understanding some of the basics of this rather intricate market better prepares us to evaluate some of the policy proposals being discussed. Further, I wonder if the rather unique structure of the bond market makes it more or less sensitive than the equity market to certain policy actions. Think about that for awhile and then share your thoughts. In the meantime, when you read that Italy’s bond auction drew yields above 6%, you’ll now know that means that Italy has to make larger interest payments on its bonds to increasingly more counterparts. And you will also know that those counterparts are a global group of largely financial firms/investors.

What are your thoughts on the recent slew of Italian bond market headlines? Did the walk through some of the bond market basics help? If you are an educator, please share how you have incorporated the recent EU sovereign debt troubles into your economics or finance classes.

Check out this interesting private report on the structure of global financial markets from Russell Index: (http://www.russell.com/indexes/documents/research/structure-global-equity-markets-July2010.pdf)

SIFMA (Securities Industry and Financial Markets Association) Statistics: http://www.sifma.org/research/statistics.aspx

4 thoughts on “Back to the Basics: Interpreting the Bond Market”

  1. I mostly agree with the first post. Interest rates usalluy start to rise when the economy is doing better. When the economy is doing better then the companies that sold the junk bonds generally are more secure so the interest rates for junk falls or stays the same. And the higher yield becomes more attractive. But that only works for a while. When Fed starts raising rates high enough to slow the economy then junk gets hurt more because they more risky and generally more in debt. To simplify they perform better at first and worse later because you are weighing two factors, interest rates against default risk.

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