Introduction to Bond Markets

What are Bonds? Have you ever borrowed money from someone? Governments and corporations issue bonds to borrow funds from investors. You can think of a bond as an IOU given by a borrower (the issuer) to a lender (the investor). Thousands of investors each lend a portion of the capital (money) needed by the issuer.

Bond basics Bonds are known as fixed-income securities because you know the exact amount of cash you'll get if you hold until maturity. Bonds pay interest payments every year (Usually twice a year, or “semiannually”.) By purchasing debt (bonds) an investor becomes a creditor to the corporation (or government). A creditor has a higher claim on assets than stockholders if the company goes bankrupt. The risk of bankruptcy or nonpayment by the issuer is called “Default Risk”.

Bonds vs. Stocks Bonds are debt, stocks are equity. Bondholders do not share in the profits if a company does well. There is generally less risk in owning bonds than in owning stocks, but this comes at the cost of a lower return.

Advantages of Bonds over Stocks to Investors Safety Reliable income Potential for capital gains Diversification Tax advantages

Who issues bonds? Default Risk* Bonds are issued by: Governments 2) Municipalities (state and local government) 3) Corporations Very Low Low Moderate *The higher the default risk, the more the bond must pay to attract investors.

United States Government Bonds Classified according to the length of time to maturity. “T” for Treasury. T Bills: maturing in less than one year. T Notes: maturing in 1 to 10 years. T Bonds: maturing in more than 10 years. US Government debt is considered extremely safe, “risk free”. The debt of many developing countries, however, does carry substantial risk of default.

Municipal Bonds “Munis” are issued by state and local governments. Cities don't go bankrupt that often, but it can happen. Munis returns are free from federal tax. Also, local governments will sometimes make their debt non-taxable for residents, thus making some municipal bonds completely tax free.

Corporate Bonds Corporate bonds have higher yields because there is a higher risk of a company defaulting than a government. The company's credit quality is very important: the higher the quality, the lower the interest rate the investor receives. Bonds are rated based on their quality ranging from “investment grade” to “junk”.

Risks of Bonds Bonds are generally less risky than stocks, but they do suffer from several types of risk. NOTHING is risk free: Credit risk Reinvestment risk Purchasing power risk Call risk Liquidity risk Foreign exchange risk Bond risk

Bonds prices and interest rates An interest rate is the price a borrower pays for using someone else's money. When market interest rates rise, the prices of existing bonds in the market fall and vice versa. Investors are willing to pay more for a bond that has higher coupon payments. This leads to bonds selling at a premium (over par, > $1,000) or discount (under par, < $1,000)