One of my readers, Natalia, asked me: “How does the bond market work?” If anyone else has a question about investing or personal finance, please write me a message.
The bond market is a financial market where investors can buy and sell bonds issued by companies, governments, and other institutions. When a bond is issued, the issuer borrows money from the investor and promises to pay interest on the bond at a fixed rate for a specified period of time. At the end of that period, the issuer repays the principal amount of the bond to the investor.
The bond market works in the following way:
- Bond issuance: Companies, governments, and other institutions issue bonds to raise funds for various purposes, such as financing projects, expanding operations, or paying off debt.
- Bond pricing: The price of a bond is determined by supply and demand. When demand for a bond is high, the price will increase, and when demand is low, the price will decrease.
- Bond trading: Bonds can be bought and sold on the secondary market, which is where investors trade bonds with each other. The secondary market is where most bond trading takes place.
- Interest rates: The interest rate on a bond is determined by various factors, including the creditworthiness of the issuer, the term of the bond, and prevailing market conditions. Higher-risk bonds typically have higher interest rates, while lower-risk bonds have lower interest rates.
- Bond ratings: Bond issuers are assigned credit ratings by rating agencies such as Standard & Poor’s, Moody’s, and Fitch. These ratings are based on the issuer’s creditworthiness and the likelihood of defaulting on the bond.
- Bond maturity: Bonds have a fixed maturity date, which is the date when the issuer must repay the principal amount of the bond to the investor. Bond maturities can range from a few months to several decades.
Overall, the bond market provides investors with a way to earn a fixed income and provides issuers with a way to raise funds.
How do individuals invest in the bond market
There are several ways for individuals to invest in the bond market:
- Individual Bonds: One way to invest in bonds is to purchase individual bonds directly from the issuer or through a broker. This can be done by opening an account with a brokerage firm, and then selecting and purchasing individual bonds from their offerings. The minimum investment for individual bonds can vary, but is typically higher than other bond investment options.
- Bond Funds: Another way to invest in bonds is through bond mutual funds or exchange-traded funds (ETFs). These funds invest in a diversified portfolio of bonds, which can include corporate bonds, government bonds, and other types of fixed income securities. This allows investors to achieve greater diversification and can have lower minimum investment requirements.
- Bond UITs: Bond Unit Investment Trusts (UITs) are investment companies that invest in a fixed portfolio of bonds. The UIT holds the bonds until maturity and then returns the proceeds to investors. UITs provide the opportunity for investors to invest in a diversified portfolio of bonds with a fixed maturity date.
- Bond ETFs: Bond ETFs trade on exchanges just like stocks, and provide exposure to a diversified portfolio of bonds. Bond ETFs can offer lower expenses and trading fees, with the ability to trade throughout the day.
- Robo-advisors: Some robo-advisors also offer bond investment options as part of their portfolio construction. These platforms use algorithms to create customized portfolios based on an individual’s investment goals and risk tolerance.
It’s important to consider your investment goals and risk tolerance before investing in bonds. Bonds generally offer a lower risk and lower potential return than stocks, but can be an important component of a well-diversified portfolio. It’s recommended to consult with a financial advisor before making any investment decisions.
My answer to Natalia
Here is your answer, Natalia. Assume that one of your uncles wants to borrow from you $100 for one year and he is promising to pay you 10% interest. You agree to lend him the money. You give him the money and in return, he gives you a piece of paper that he calls a “Bond” with a “Face Value” of $100 and a coupon (interest rate) of 10%.
Six months later, you need the money and you want to sell your bond. While having dinner with your family you declare that you want to sell this Bond to anyone who is willing to buy it.
Let’s say that your sister wants to buy the bond, but 6 months have already passed, so you have earned 5% ( if one year is 10%, then 6 months is 5%), so you don’t want $100, you want at least $105. This additional $5 above the face value of the bond is called “a premium.”
Let’s change the scenario a bit. Let’s say that your uncle loses his job and he is having a hard time paying his bills. You become worried because you are afraid that he might not be able to pay you back. You offer the bond to your sister for $95. Your sister has confidence that your uncle will be able to pay his bond and she buys it from you. She is buying the bond for $5 less than what you paid for it, this difference in value is called “a discount.”
In the real bond market, companies, cities, and governments need to borrow money all the time; they borrow money by selling bonds. Generally, they sell all their bonds to one financial institution like the Royal Bank or to a consortium of financial institutions (Royal Bank, TD Bank, BOM). This direct sale from the borrower to the financial institutions is called the primary market. Then the financial institutions sell the bonds to the general public, the general public is the secondary market. Once the bond is out on the secondary market, people buy those bonds from each other as if they were buying stocks.
There are many factors that determine the price of a bond, but two of the most important are the risk and the interest rate.
Risk: If a company or a government has a good reputation, lets say Google, then people feel comfortable holding those bonds and would even pay more, but if a company is on the brink of bankruptcy, like Nortel, then the value of the bonds is lower, people will be willing to sell those bonds to someone else, even at a loss.
Interest rates: If the government increases interest rates, bond prices fall. Let’s say that the government increases interest rates from 2% to 5%. People will want to get rid of the bonds that were paying 2% to be able to buy the new bonds that are now paying 5%. They will be so desperate to sell the 2% bonds that they will sell them at a discount, and therefore driving the prices down.
The safest bonds are those issued by the federal government. If ever the government doesn’t collect enough tax dollars to pay back the bondholders, they can always go to their photocopy machine and print more money. Many people feel that with the escalating debt of the United States, one-day people would not be willing to lend them money anymore. Their national debt is over 17 Trillion dollars. Canada’s debt is about $680 Billion.
When people invest in bonds, they get a lower return for their money than they would have gotten by investing in stocks, but bonds are a lot less volatile and its earnings more predictable. Many money managers recommend having a portfolio composed of mostly stocks for younger people and a portfolio mostly of bonds for people close to their retirement.
I have grossly oversimplified the bond market. I have never traded in it and I don’t know anyone personally who has traded in it. Nevertheless, investing in the bond market is a fundamental part of personal finance and the economy and at the very least we should all understand how it works.