Introduction to bond markets
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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).

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Introduction to Bond Markets

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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

*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)


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