The bond market is an integral part of the world economy. This post will cover what bonds are, the history of bond markets, types of bond markets, why you should care about the bond market vs. the stock market, and more!
What Is a Bond and a Bond Market?
A bond is a loan that has been repaid with interest in advance. A company issues bonds when they want to borrow money but don't have enough cash on hand or chooses not to spend it at that time. It can also be a way to reward shareholders by giving them a percentage of the company's profit. The bond market is an integral part of the world economy because it's where companies and governments borrow money.
Types of Bond Markets
There are two significant types of bond markets: corporate and sovereign. The sovereign market is typically used for buying bonds issued by governments. Still, other types of bonds can be purchased from various organizations, including corporations and governments. Corporate bonds are also known as commercial paper or asset-backed securities. They aren't as widely used as they once were because they don't pay interest. However, they can still be valuable if the company defaults on its loan (called a "payment default").
Corporate bonds are usually issued for between one and ten years. Still, it's not uncommon to find bonds with a maturity of twenty years or even more. Bankers, investors, and governments buy corporate bonds because they're secure but come with a greater degree of risk. Governments and large investment companies typically lend money to corporations, which helps the economy grow. Corporations can develop new technology or build better factories based on the cash received from selling the bond. When this happens, it lowers unemployment rates and makes it easier for people to find good jobs with competitive wages.
Factors Affecting Bond Prices
Bond prices are affected by interest rates (which can go up or down), the condition of the borrower, whether or not you're buying an investment-grade bond or a non-investment grade bond (which has a greater risk of being repaid), and economic conditions such as inflation rates and external market factors.
Bond and Interest Rates
Interest rates can increase or decrease depending on supply and demand in the bond market. The higher the interest rate, the more interest you'll receive on your loan. You've probably noticed this if you've ever had a savings account before. A $1,000 savings account that compounds interest at 5% per year means that your account will be worth $1,050 at the end of one year.
Creditworthiness
A company's creditworthiness can be tested by looking at its debt-to-equity ratio, which is the value of its assets used up by its debt. A high ratio indicates a risk of default on interest payments.
Bonds are relatively safe investments if they're investment grade. A non-investment grade bond has a much greater risk of being repaid because it's issued by a company or government with a higher risk of defaulting on its loan. Bonds issued by the US government are considered the best investment in the world because the government's debt is backed by America's full faith and credit. Americans have been able to pay off their national debt to date (although people have argued about this over time).
Inflation and Bond Prices
Inflation will cause the price of your bond's interest payment to go down if the principal amount goes up faster than the interest rate. Inversely, deflation will cause the cost of your bond to go up. When calculating whether or not a bond would be an appropriate investment for you, you should look at its inflation-adjusted yield. This is usually referred to as "real yield."
Due to inflation, bonds are typically attractive because their payments go up over time. On the other hand, gold is most attractive when inflation rates are low. Of course, if you invest in gold during times of high inflation, it will decrease in value the same way that bonds do.
Investment Grade vs. Non-Investment Grade Bonds
Investment-grade bonds tend to be safe investments because they're issued by companies with a lower risk of defaulting on their loan. non-investment-grade bonds may provide higher returns than investment-grade bonds. Still, they also come with more significant risks of being repaid (i.e., you have a greater risk of losing your money).
Investment-grade bonds are issued by companies and government agencies that you're probably already familiar with. They also tend to be rated by one of the following credit rating agencies: Fitch, Moody's, and Standard &'' Poor's.
Region of Issuance
Bonds issued in the same region as where you live will often come with higher yields because you're helping your own community by investing in it, which means you're less likely to lose your money.
When deciding whether or not to invest in a bond, look at the region of its issuance and whether or not it's being issued by companies within your own country. The more you can invest in your own country's bonds, the more likely you'll be to collect your interest payments when they're due. If you choose to invest in other countries' bonds, it may take years to get back what you lend.
International Bond Lenders
Some banks will allow their clients to invest internationally. These banks may offer international "corporate" loans or loan themselves money (which is called an "offshore" loan). If a bond issued by a company in another country is being sold on the secondary market (through a broker), then it's being bought by investors who want to sell their right to receive regular interest payments from the business with which they invested. You may be able to receive a higher interest payment by investing in a bond issued by your local area bank versus an overseas company. There is always some risk involved, though, especially for international corporations doing business in another country.
