Financial instruments worth $ 100 trillion dollar market — Financial Literacy 101
In this segment of Financial Literacy 101, we are going to start in a more “visual” way this time, putting our brains to work.
Without further ado, let’s look at the picture below:
What you are seeing is the size of the whole WORLD ECONOMY, divided by country and their Gross Domestic Product (or GDP) — a monetary measure of the market value of all the final goods and services produced in a specific time period by countries.
Pretty staggering isn’t it?
Now let’s look at the following chart:
You might ask, “what the heck is this?” and “how can there be a market even bigger than the world economy itself?”
The answer and today’s topic of analysis is the BOND market.
A Bond is essentially a debt security following the basic principle of
I OWE YOU.
Borrowers issue bonds to raise money from investors willing to lend them money for a certain amount of time in exchange for regular interest payments.
When you invest in a bond — since you are lending to the issuer — you are a debtholder for the entity that is issuing the bond.
The bond market is by far the largest securities market in the world, providing investors with virtually limitless investment options while, on the other hand, are helping both:
— Governments, who sell bonds for funding purposes and also to supplement revenue from taxes;
— Companies, that sell bonds to finance ongoing operations, new projects, or acquisitions.
Therefore it’s correct to say that bonds are essentially loans made to large organizations and, for this particular feature, are deemed “financial securities” and cost of it, seen by the majority of investors as a safe financial tool delivering a fixed-income (because the likelihood of a government to default is extremely low — albeit not impossible).
Broadly speaking government bonds and corporate bonds remain the largest sectors of the bond market, but other types of bonds, including mortgage-backed securities, play crucial roles in funding certain sectors, such as housing, and meeting specific investment needs.
This massive capital market is comprised of several types of bonds:
Treasury bonds are backed by the government and are considered one of the safest types of investments.
These fixed-income securities are issued and backed by the full faith and credit of the government — which will have to find a way to repay its debt. The flip side of these bonds is their low-interest rates. There are several types of Treasury bonds (bills, notes, bonds) that differ based on the length of time till maturity.
U.S. bonds only comprise about 40% of the global market. As of Dec. 31, 2020, foreign governments and corporations had over $70 trillion of bond debt outstanding.
A large portion of this debt was funded by U.S. investors seeking meaningful diversification benefits and the opportunity to enhance the yield on their fixed-income holdings. That said, international bonds exhibit elevated levels of risk, especially in emerging markets.
Corporate bonds are issued by public and private companies to fund day-to-day operations, expand production, fund research, or finance acquisitions.
States, cities, and counties issue municipal bonds to fund local projects. Interest earned on municipal bonds is tax-free at the federal level and often at the state level as well, making them an attractive investment for high-net-worth investors and those seeking tax-free income during retirement.
- MATURITY: The date on which the bond issuer returns the money lent to them by bond investors. Bonds have short, medium, or long maturities.
- FACE VALUE: Also known as par, face value is the amount your bond will be worth at maturity. A bond’s face value is also the basis for calculating interest payments due to bondholders. Most commonly bonds have a par value of $1,000.
- COUPON: The fixed rate of interest that the bond issuer pays its bondholders. Using the $1,000 example, if a bond has a 3% coupon, the bond issuer promises to pay investors $30 per year until the bond’s maturity date (3% of $1,000 par value = $30 per annum).
- YIELD: The rate of return on the bond. While coupon is fixed, yield is variable and depends on a bond’s price in the secondary market and other factors. Yield can be expressed as current yield, yield to maturity, and yield to call (more on those below).
- PRICE: Many, if not most bonds, are traded after they’ve been issued. In the market, bonds have two prices: bid and ask. The bid price is the highest amount a buyer is willing to pay for a bond, while ask price is the lowest price offered by a seller.
- DURATION RISK: This is a measure of how a bond’s price might change as market interest rates fluctuate. Experts suggest that a bond will decrease 1% in price for every 1% increase in interest rates. The longer a bond’s duration, the higher exposure its price has to changes in interest rates.
- RATING: Ratings agencies assign ratings to bonds and bond issuers based on their creditworthiness. Bond ratings help investors understand the risk of investing in bonds.
- Moody’s, Standard and Poor’s, Fitch Ratings, and DBRS are some of the most internationally well-known bond-rating agencies.
Imagine The Coca-Cola Company wanted to borrow $10 billion from investors to acquire a large tea company in Asia. It believes the market will allow it to set the coupon rate at 2.5% for its desired maturity date, which is 10 years in the future. It issues each bond at a par value of $1,000 and promises to pay pro-rata interest semi-annually. Through an investment bank, it approaches investors who invest in the bonds. In this case, Coke needs to sell 10 million bonds at $1,000 each to raise its desired $10 billion before paying the fees it would incur.
Each $1,000 bond will receive $25.00 per year in interest. Since the interest payment is semi-annual, it will be $12.50 every six months. If all goes well, at the end of 10 years, the original $1,000 will be returned on the maturity date, and the bond will cease to exist.
We can further classify bonds according to the way they pay interest and certain other features:
- Zero-Coupon Bonds: As their name suggests, zero-coupon bonds do not make periodic interest payments. Instead, investors buy zero-coupon bonds at a discount to their face value and are repaid the full face value at maturity.
- Callable Bonds: these bonds let the issuer pay off the debt — or “call the bond” — before the maturity date. Call provisions are agreed to before the bond is issued.
- Puttable Bonds: Investors have the option to redeem a puttable bond — also known as a put bond — earlier than the maturity date. Put bonds can offer single or several different dates for early redemption.
- Convertible Bonds: These corporate bonds may be converted into shares of the issuing company’s stock prior to maturity.
While stocks seem to steal the spotlight in the major news channels, their total market still sits short of “just” 34.6 trillion dollars ($93.7 trillion) when compared to the bond market ($128.3 trillion).
Source: ICMA analysis using Bloomberg Data (August 2020)
That alone should be enough to put things in perspective and clearly state the size of this “behemoth” market.
The core question is though:
What determines the price of a bond in the open market?
These instruments can be bought and sold in the “secondary market” after they are issued. While some bonds are traded publicly through exchanges, most trade over-the-counter (OTC) between large broker-dealers acting on their clients’ or their own behalf.
A bond’s price and yield determine its value in the secondary market. Obviously, a bond must have a price at which it can be bought and sold, and a bond’s yield is the actual annual return an investor can expect if the bond is held to maturity. Yield is therefore based on the purchase price of the bond as well as the coupon.
The bond price and yield have an “INVERSE CORRELATION,” hence why the bond’s price always moves in the opposite direction of its yield.
Put simply, when interest rates are rising, new bonds will pay investors higher interest rates than old ones, so old bonds tend to drop in price.
Falling interest rates, however, mean that older bonds are paying higher interest rates than new bonds, and therefore, older bonds tend to sell at premiums in the market.
Bonds, like many investments, balance risk, and reward. Typically:
- bonds that are lower risk = pay lower interest rates;
- bonds that are riskier = pay higher rates in exchange for the investor giving up some safety.
Bonds, like all assets, move in value, so your investment of $100 today may go up or down in value, and the investor can trade bonds as their price moves up and down.
We can summarize the main reasons people invest in bonds in 3 arguments:
- Stable income stream:
Bonds pay interest (coupon payments) at regular intervals and can provide a stable and predictable income stream. The interest rate you can earn on a bond may be higher than a savings account or term deposit;
- Lower risk:
Bonds are defensive investments and lower risk than growth investments like shares or property.
The amount of risk depends on the issuer of the bond: either the Government (lowest risk) or a company (higher risk);
- Diversification of the investment portfolio:
Bonds are often used to diversify a portfolio. Diversification lowers the risk in a portfolio because no matter what the economy does, some investments are likely to benefit.
For example, when interest rates fall, bond prices rise, while shares often fall at this time.
But beside all their inherited safety, bonds still present DISADVANTAGES and some levels of risk:
- Bonds Yield Lower Returns Than Stocks
While the fixed return is attractive for investors who cannot stomach the volatility of other instruments, the total return of bond investments can leave a person feeling a little hollow at the time of its maturity.
This means that if you lock in a large sum of money in a 10-year government bond at 1.61%, you could be missing out on tens of thousands of dollars (perhaps more) if the stock market performs anywhere near its historic averages.
The value of the S&P500 kept increasing on the long-term, despite an extensive amount of financial crisis
- Larger Investment Sum Needed for Bonds
Many bonds are used to fund large-scale public or corporate projects that cost millions of dollars. As a result, even the smallest bonds issued for such projects may run into five or six figures. This can put bonds out of reach for some investors, who have the ability to purchase fractional shares of their favorite stock for as little as $1.
- Bond Defaults Can Occur
As a form of debt, bonds are more secure than stocks in the event of a bankruptcy. However, there are cases when a company is in such a bad financial situation that it cannot pay back its debts, causing them to default on its loans and bonds. Therefore, it is essential to look at the bond rating and research the company’s financial health before purchasing a bond.
Remember, the riskier bonds will often yield a higher return, but will also have a great fault of defaulting.
- Bonds are Less Liquid Than Stocks
Stocks are close to perfectly liquid asset. Bonds, on the other hand, are extremely low in liquidity. The bondholder will not be paid back the principal of the investment until the bond reaches maturity, usually 10, 20, or even 30 years down the road. For those who are in need of liquid cash, they’ll want to stay away from bonds as these long maturity dates can often be problematic in the event of a financial emergency.
- Interest Rate Risk
Arguably the most direct threat to bonds is interest rate risk. When an investor purchases a bond, they are locked into that rate for the bond’s term. If interest rates increase the day after the bond is purchased, the bondholder will be stuck getting unfavorable returns for the life of the bond.
Bearing this in mind, the intelligent investor should purchase bonds of varying maturity lengths to help spread out interest rate risk.
1. A bond’s interest rate is tied to the creditworthiness of the issuer.
U.S. government bonds (for instance) are typically considered the safest investment. Bonds issued by state and local governments are generally considered the next safest, followed by corporate bonds. Treasuries offer a lower rate because there’s less risk the federal government will go bust. A sketchy company, on the other hand, might offer a higher rate on bonds it issues because of the increased risk that the firm could fail before paying off the debt. Bonds are graded by rating agencies such as Moody’s and Standard & Poor’s; the higher the rating, the lower the risk that the borrower will default.
2. How long you hold onto a bond matters.
Bonds are sold for a fixed term, typically from one year to 30 years. You can sell a bond on the secondary market before it matures, but you run the risk of not making back your original investment or principal. Alternatively, many investors buy into a bond fund that pools a variety of bonds in order to diversify their portfolios. But these funds are more volatile because they don’t have a fixed price or interest rate. A bond’s rate is fixed at the time of the bond purchase, and interest is paid on a regular basis — monthly, quarterly, semiannually, or annually — for the life of the bond, after which the full original investment is paid back.
3. Bonds often lose market value when interest rates rise.
As interest rates climb, so do the coupon rates of new bonds hitting the market. That makes the purchase of new bonds more attractive and diminishes the resale value of older bonds stuck at a lower interest rate.
4. You can resell your bond.
You don’t have to hold onto your bond until it matures, but the timing does matter. If you sell a bond when interest rates are lower than they were when you purchased it, you may be able to make a profit.
If you sell when interest rates are higher, you may take a loss.
Like all financial decisions, contemplating whether or not it makes sense for you to invest in bonds is a highly personalized matter that depends on your unique situation and goals.
Bonds could be an excellent investment for one person, but they could be a very poor choice for another. The investor should evaluate possible bond alternatives before settling on this investment vehicle.
Bonds tend to make more sense for investors with a relatively low tolerance for risk. Oftentimes, these characteristics relate to retirees that have begun to draw down on their hard-earned savings. Retirees present a relatively short investing horizon, and they can’t withstand extreme levels of volatility.
In a well-diversified investment portfolio, bonds can provide both stability and predictable income.
I will add, though, that, besides being seen as the preferred financial investment vehicle for long term, fixed-income investors, bonds are being profoundly evaluated due to the current spike in INFLATION rate, which has brought investors to reexamine the reliability of such instruments to outpace this monetary phenomenon, eroding purchasing power — and the increasing trend of DISTRUST in Governments with their questionable monetary policies.
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