How Bonds Impact You
The next time you drive on a smoothly paved highway, borrow a new DVD from your library, see an office park rising up in your neighborhood or hear of a factory expansion that’s creating new jobs, consider the role of the U.S. bond market. Even bigger than the stock market, the largest securities market in the world plays a vast and vital role on the global stage, in the U.S. economy, and the daily life of every American. The outstanding value for all U.S. debt issues went from $12 trillion in 1996 to more than $35.9 trillion in 2010.*
BOND MARKET RELATIVE TO STOCK MARKET
Average Daily Trading Volume (in 2009)*
U.S. Bond Markets $814.0 Billion
Stock Market (on NYSE, NASDAQ, AMEX) $104.9 Billion
The bond market provides local, state and federal governments, and private enterprises the funds needed to get development and long-term infrastructure projects off the ground. Before people are hired, earth moved, concrete poured, or products rolled off the factory floor, capital needed for the work is in place. Chances are bond issues help raise the funds to get started on projects that help maintain our quality of life, well-being and U.S. competiveness.
The issuance and purchase of bonds help lower costs of infrastructure renovation and replacement for public works, as well as for new and expanding businesses. Among many examples, bonds help build bridges, roads, transportation systems, power plants that light and heat our homes, reservoirs and pipes that bring us water, sewer systems and factories that produce products fundamental to our daily lives. Without bonds to finance these projects in a timely way, these systems would erode and break down. By the end of 2010, issuance in the U.S. bond markets had reached $6.7 trillion.
In addition to financing long-term infrastructure projects, bonds help governments manage the ebb of its cash flow, passing savings onto taxpayers who help the government pay for needed services, such as those provided by military, police, hospital staff, school teachers, and others.
How Bonds Work
Clearly, bonds are one way our public and private institutions borrow billions and billions of dollars. A bond is similar to a loan or an IOU. When you purchase a bond, you are like a mini-banker lending to a large borrower, such as a corporation or government entity.
The borrower (the issuer of the bond) makes a legal promise to repay the amount borrowed back (known as the principal or the bond’s par or face value) to the bondholder on a specific future date (known as the redemption or maturity date) plus interest (known as the coupon rate or coupon) at a periodic rate, usually twice a year. For the borrower or issuer, the interest expense is the cost of borrowing; for the investor, the dependable interest income is compensation for lending the money.
Investments in bonds have burgeoned since the beginning of the 21st Century. Today’s U.S. bond market exceeds a hefty $34 trillion. The bond market is collectively made up of an array of sectors within the credit market, with each category of bond consisting of its own network and trading system.
Types of Outstanding Bonds (in trillions)*
- Municipal: $2.93
- Treasury: $8.85
- Mortgage-Related: $8.91
- Corporate: $7.54
- Federal Agencies: $2.73
- Money Market: $2.86
- Asset-Backed: $2.15
Bonds typically are not bought directly from the issuers (An exception are bonds issued by the U.S. government). Broker-dealers at banks or brokerage houses, known as the underwriter, act as intermediaries between the issuer and the bond buyer. The underwriter buys the bonds from the issuer and then resells the bonds to investors, bringing them to market. When the bond makes its debut, the new issues are purchased in what is called the primary market. If the bondholder wishes to sell the bond before maturity, the bond is sold in what is called the secondary market — where bonds that have been previously owned are sold.
Bonds, unlike stocks, are mostly bought and sold, and resold in the over-the-counter (OTC) market, which is made up of networks of independent national and regional dealers, organized by type of bonds. There is not one large organized exchange where bond buyers and sellers trade. However, small quantities of bonds in the secondary market do trade on the New York Stock Exchange and the American Stock Exchange and fewer on the NASDAQ.
When bonds make their debut at issue or when they enter the secondary market they can be purchased through full-service, online or discount brokers, and investment and commercial banks. The inventory and selection of bonds vary from dealer to dealer. So, the pricing of a particular bond may also vary. When buying or selling a bond through a brokerage firm, an individual investor will be charged a commission or spread, which is the difference between the market price and cost of purchase, and sometimes a service fee. Spreads differ based on several factors including liquidity. To bypass pricing individual bonds, investors may consider bond mutual funds or bond exchange-traded-funds (ETFs).
The pricing of bonds, however, has become more transparent in recent years due to industry regulation and partnerships. Click on the following links to see the Financial Industry Regulatory Authority’s (FINRA) TRACE system and the Municipal Securities Rulemaking Board’s transaction reporting system EMMA.
Who Buys Bonds
A broad universe of institutions and individuals purchase bonds. As investments, bonds can provide a means of preserving capital and earning a predictable return. Bond investments create steady streams of income from investment payments prior to maturity. Bonds can also provide downside investment protection against the more volatile movements of the stock markets.
Pension funds, insurance companies, banks, and corporations are the biggest customers, buying bonds to have stable sources of cash flows to meet predictable obligations. For example, insurance companies use the regular interest payments to meet obligations from policies they sell. Government and business with big pensions buy bonds in order to ensure that capital is in place to meet obligations for retired employees and beneficiaries. Mutual funds and international investors, such as central banks, are also big investors.
- Pension Funds
- Insurance Companies
- Mutual Funds/401K
- Households (Individual Investors)
- International Investors
- Financial Institutions
Why Bond Prices Fluctuate?
Not all bonds are the same. Primarily two factors affect the worth of a bond after issuance. Bond prices go up and down depending on interest rate changes and fluctuations in credit quality.
The safety of a bond depends on the issuer’s relative ability to pay the interest and return the principal as promised. The better the reputation and stability of the issuer, the less risk and more certainty that investors will receive what they are owed. Consequently, the interest rate paid on higher rated bonds, like those backed by the U.S. Treasury or federal agencies, is lower. Quality debt depends on the reliability of the issuer: The greater the ability to meet interest and principal payments, the higher the credit rating by the major rating agencies.
For corporations the story is similar except that companies typically pay a higher interest rate than the highest rated governments because companies cannot offer the same guarantee of repayment. The possibility of default or bankruptcy exists. If a company, however, runs into financial trouble, bondholders have legal priority to repayment of principal before stockholders receive any payment. Companies with financial heft, a history of success, good business practices, and a track record for paying debts, issue bonds with lower interest rates than companies with lesser ratings.
The level of risk a bondholder incurs is also affected by the length or maturity of the bond. The longer the bond is in circulation the more time for significant moves in the prevailing interest rate. As rates move up or down, so does the market value of the bond. When interest rates go up prices of existing bonds go down. New issues offering higher coupons come along, so bonds with a coupon yielding less interest are less attractive and the prices drop.
Generally speaking when interest rates go down, the prices of bond issues go up. Interest rates change in response to a number of factors — changes in supply and demand for credit, fiscal policy, exchange rates, economic conditions, and crucial for the bond market, changes in expectations of inflation. High inflation reduces the future buying power of interest payments and the value of the principal.
The most widely traded bond in the U.S. and the world is the 10-year Treasury bond. Following the yield on this key security — the “bellwether” of the bond market — the long bond helps guide investors on interest rate levels, gaining a sense of where the market perceives interest rates will be heading.
U.S. Treasury Market
Treasuries, debt securities issued by the Department of the Treasury on behalf of the Federal government, carry the full faith and credit backing of the U.S. government, making it the safest and most popular of investments. The amount of marketable U.S. Treasury securities is huge, with $8.85 trillion in outstanding bills, notes, and bonds as of the end of 2010. Trading volume in Treasury securities averaged $949.8 billion a day in 2010.
The liquidity and efficiency of the Treasury market allows the federal government to finance ongoing operations in an efficient way at the lowest possible cost to taxpayers over time.
The Federal Reserve System, through the New York Federal Reserve Bank, uses the Treasury market to implement monetary policy. In order to increase the money supply, it buys Treasury securities, injecting funds into the economy and reducing interest rates. To reduce the money supply, it sells Treasury securities, taking money out of the economy and raising interest rates. In this way, the Fed attempts to manage price inflation in the economy. The most widely circulated type of bond is bought and sold by a wide swath of global investors — individual investors, pension funds, money market funds, commercial banks, insurance companies, corporations, state and local governments, and securities dealers. Many large institutional investors like pension funds and mutual funds also hold treasuries to benefit individuals.
Treasury securities come in the three forms — new issues of bills, notes and bonds, including TIPS (Treasury Inflation-Protected Security, whose principal amount is adjusted for inflation). Bills have maturities of one year or less; notes mature between two and ten years, and bonds mature between 20 years to 30 years.
Investors can buy or sell Treasuries by holding an account at a brokerage firm. Treasury securities are also sold directly via the government, which holds regularly scheduled auctions. See the website at www.TreasuryDirect.gov, the Treasury Department’s primary retail system for selling securities. By setting up an account at Treasury Direct an individual investor can also sell Treasuries in the secondary market through a Treasury program called Sell Direct.
Municipal Securities Market
Tens of thousands of state and local governments issue bonds to build, repair and improve schools, streets, hospitals, airports and many other public works. Encompassing a diverse group, municipal bonds, popularly called “munis” on average traded a daily $15.0 billion in 2010, totaling some 41,643 trades a day Municipal bonds, as a whole, are among the least risky of investments.
When the federal income tax law was adopted in 1913, the interest income on most municipal bonds was excluded from federal taxation. Further, if you live in the state where the municipal bond is issued, the interest is also free from state income tax. In some cases, an issue can be triple tax exempt — federal, state, and city. As a result, municipal bond investors are willing to accept lower yields for tax-exempt instruments than for from taxable investments. Municipal bonds present the greatest opportunities for those in the highest tax brackets, providing a higher tax-free yield compared to an equivalent yield of a taxable bond (known as taxable equivalent yield).
For state and local governments, issuers can borrow at interest rates that are, on average, 25 percent to 30 percent lower than would otherwise be possible.
The Build America Bonds program, created a new kind of municipal bond and was first authorized under the Stimulus Act of 2009, the program expired at the end of 2010. However, President Obama’s fiscal 2012 budget, which he released on February 14, 2011, proposes to permanently reinstate the Build America Bonds (BABs) program.
Generally, municipalities issue their bonds in two ways:
- General Obligation Bonds (GO Bonds)
- Revenue Bonds
Typically, projects that benefit the entire community, such as schools, courthouses and municipal office buildings, are funded by general obligation bonds, which are repaid by tax revenues. Projects that benefit only their users, such as utilities, airport facilities and toll roads, are typically funded by revenue bonds, which are repaid with fees collected from people who use the services or facilities.
GO bonds are backed by the full faith and credit of the government entity issuing the bond and its taxing power. Revenue bonds are relatively riskier, since unlike GO bonds, they depend on the success of the specific project they are issued to fund, such as toll bridges or airport facilities, to pay interest to bondholders. Revenue bonds issued for essential services, however, such as electric power, or water or sewer systems, do provide reliable income streams and are often of high credit quality.
Historically, very few municipal bonds have defaulted, with a record of safety second only to that of U.S. Treasury securities. Even as conservative investments, municipal bonds, like all investments, carry risk and vary in quality and returns.
Issuers of municipal bonds have a record of making interest and principal payments in a timely manner. Issuers disclose details of their financial condition through “official statements” or “offering circulars,” which are available from your bank, brokerage firm, or on the Internet or through the Municipal Securities Rulemaking Board’s Electronic Municipal Market Access (EMMA) website at http://emma.msrb.org. The MSRB’s portal EMMA also provides free access to annual continuing disclosure about the financial condition of an issuer as well as additional specific data on individual municipal securities. Another way to evaluate an issuer is to examine its credit rating. Many bonds are graded by ratings agencies such as Moody’s Investors Service, Standard & Poor’s and Fitch Ratings.
Corporate Bond Market
Corporations use the funds they raise from selling bonds for a variety of purposes, from building facilities to purchasing equipment to expanding their business. The U.S. corporate bond market is large and liquid, with daily trading volume estimated at $16.3 billion. Issuance for 2010 was an estimated $1.03 trillion. Outstanding corporate debt stands at $7.5 trillion in 2010, accounting for more than 20 percent of U.S. fixed-income securities. The number stands in contrast to European corporate bonds, which represent a markedly smaller percentage.
The U.S. corporate bond markets have long been an important source of capital for issuers. Early IOUs or debt obligations financed the country’s westward expansion, building the transcontinental railroad and Erie Canal.
In deciding how to raise capital for investment, corporations can issue equity securities, borrow in the debt markets or pursue a mix of both. The driving force behind a corporation’s financing strategy is the need to minimize its cost of capital. Corporations have historically relied on the public debt markets as well as bank lending facilities to fund their business but have more recently begun to rely more heavily on the public markets as the banking crisis has limited bank lending.
Investors in corporate bonds include both individuals and large financial institutions such as pension funds, endowments, mutual funds, insurance companies and banks. Individuals, from the very wealthy to people of modest means, also invest in corporates because of the benefits these securities offer. Corporate bonds typically yield more than other taxable bonds but can be complex due to considerations of credit quality, event risk like takeovers and call risk — the risk that the bonds will be redeemed by the issuer before maturity. Yields among corporate bonds can differ substantially based on the perceived credit risk of the individual corporation and the outlook for the profitability and competitiveness of its industry or sector.
To increase price transparency in the U.S. corporate debt market, in July 2002 the National Association of Securities Dealers (now the Financial Industry Regulatory Authority) introduced TRACE (Trade Reporting and Compliance Engine). The initiative mandated that all dealers and inter-dealers report the time of execution, price, yield and volume of corporate bond trades to its Trade Reporting and Compliance engine, creating the first regulatory database of the universe of OTC corporate bonds. Individual investors now can view real time price and volume information for individual corporate bonds on this site and FINRA’s website: http://finra-markets.morningstar.com/BondCenter/TRACEMarketAggregateStats.jsp
Money Market Instruments
While governments and corporations typically tap the securities markets for long-term funding needs, they may also need to issue debt for shorter periods to finance imports, to meet seasonal cash-flow needs or to create “bridge” financing until conditions are right for longer-term debt issues. To obtain this type of safe short-term financing (maturities of one year or less), they can turn to the “money market,” which includes bankers’ acceptances, commercial paper and certificates of deposit (CDs).
Used primarily in trade finance, bankers’ acceptances are guarantees of payment that permit international trade to function smoothly without the risk that goods shipped will not be paid for or that payments will be made for goods sold that don’t meet specifications. Commercial paper, typically the lowest-cost, short-term financing for creditworthy issuers, consists of unsecured promissory notes, often supported by bank credit lines, with maturities of up to 270 days, but generally extending less than a month. Foreign corporations can issue dollar-denominated commercial paper, and municipalities issue tax-exempt commercial paper or other short-term instruments to raise cash in anticipation of tax receipts or as interim financing prior to a bond sale. Certificates of deposit are negotiable debt instruments issued by banks and thrift institutions against funds deposited for specified periods.
The generally short maturities of money market instruments permit firms to be flexible in funding short-term cash needs that may fluctuate unpredictably and to take advantage of lower interest rates that typically exist in the shorter maturity ranges. Additionally, the money market’s efficiency, liquidity and size, estimated currently at $2.86 trillion, frequently make these instruments cost-effective alternative funding sources relative to bank loans.
From the investor’s perspective, money market instruments represent a liquid, low-risk investment that generally offers a higher yield than bank deposits. Mutual funds and other large investors are the principal investors in money market instruments.
Federal Agency Securities Market
Many different U.S. government agencies and government-sponsored enterprises (GSEs) issue their own debt securities to finance activities supported by public policy, such as home ownership, farming, and small-business operations. These issuers are able to borrow at favorable rates and channel the proceeds into programs that make credit available to sectors of the economy that would not otherwise enjoy such affordable sources of funding.
The federal agency market includes debt securities issued by Federal Home Loan Banks, Freddie Mac, Fannie Mae, Federal Farm Credit Banks and the Tennessee Valley Authority, among others.
Although most agency securities do not carry the government’s full-faith-and-credit guarantee, their credit quality is generally considered to be high though characteristics differ. Debt securities issued by GSEs are solely the obligation of their issuer and are considered to carry greater credit risk than securities issued by the U.S. Treasury and certain government agencies (e.g., Ginnie Mae) whose securities have the guarantee of the U.S. government. For this reason, GSE debt obligations often carry a yield premium over Treasury securities with comparable maturities. With an estimated $2.73 trillion in debt outstanding in 2010, the agency securities market is smaller than the Treasury market but functions with comparable efficiency and liquidity due to strong investor interest and competition among dealers.
Investors in agency securities are primarily institutional in nature and include state and local governments, mutual funds, pension funds, investment trusts and global investors.
Mortgage securities play a crucial role in the availability and cost of housing in the United States. The creation of mortgage securities helps individuals own homes by reducing the cost of a mortgage, allowing a potential homeowner to borrow money at the lowest rate available.
Mortgage securities represent an ownership interest in mortgage loans made by institutions, such as savings and loans, commercial banks, and mortgage companies, to finance the borrower’s purchase of a home or other real estate. Mortgage loans are combined or “pooled” by issuers or servicers, and securities backed by these loans (mortgage-backed securities) are issued for sale to investors. This process of creating securities by pooling together various cash-flow producing assets, such as residential or commercial mortgages, is referred to as “securitization.”
The securities are bought by securities dealers and sold to investors around the world. As the underlying mortgage loans are paid off by the homeowners, the investors receive monthly payments of interest and principal.
The ability to securitize mortgage loans enables mortgage lenders and mortgage bankers to access a larger reservoir of capital, to make financing available to home buyers at lower costs and to spread the flow of funds to areas of the country where capital may be scarce.
Mortgage securities come in two forms: U.S. agency and non-agency issues by private institutions. Agency mortgage securities are issued by three U.S. agencies: Government National Mortgage Association (GNMA or Ginnie Mae), which issued the first mortgage security in 1970; Federal Home Loan Mortgage Corporation (FHMLC or Freddie Mac); and Federal National Mortgage Association (FNMA or Fannie Mae). Ginnie Mae securities are backed by a government guarantee of repayment; Fannie Mae and Freddie Mac are not, but are guaranteed by the agencies. Private institutions, such as subsidiaries of investment banks, financial institutions and home builders, also package various types of mortgage pools. These non-agency mortgage securities are known as “private label,” in contrast to “agency” mortgage securities.
Investors in the $8.86 trillion mortgage securities market include institutions of all sizes: corporations, commercial banks, life insurance companies, pension funds, trust funds, mutual funds, and charitable endowments.
In the mid-1980s, the concept of transforming loans into securities gradually spread from mortgages to other types of assets such as auto loans, student loans, credit cards, equipment loans and leases, business trade receivables, and the issuance of asset-backed commercial paper, among others. Today’s asset-backed securities market provides a ready source of capital to replenish funds for lending to consumers, small businesses and other borrowers. It also gives issuers the ability to recycle capital by shifting the risks associated with carrying loan assets off of their balance sheets.
Asset-backed securities are underwritten by dealers and sold to investors around the world. As the loans are repaid by the borrowers, the cash flow of interest and principal is passed on to the investors. In some cases, credit enhancements such as bond insurance or letters of credit back the securities to make them more attractive to investors.
The asset-backed securities market has burgeoned from its formative days. In 1996 total asset-backed debt counted $404 billion. At the end of 2008, the number had reached $2.67 trillion.* Investors in asset-backed securities include pension funds, mutual funds, insurance companies, money market funds and financial institutions.
The ability of securities firms to price securities effectively and to underwrite issues of government and corporate debt depends on their ability to finance holdings of these securities in their capacities as underwriters and market makers. The funding markets (also sometimes called the repurchase or securities lending markets) are essential to the smooth functioning of all the debt markets. Highly liquid markets in debt securities require readily available funding sources. In fact, repurchase agreements (repos) are the most important source of liquidity in the Treasury and agency securities markets. This liquidity serves to lower the government’s cost of money and thereby saves taxpayer dollars. In addition, the Federal Reserve uses repo transactions to carry out monetary policy.
In a typical repo agreement, a securities dealer wishing to finance a bond position sells the bonds to a cash investor, while simultaneously agreeing to repurchase them at a later date for an agreed-upon price. The investor receives a return for providing the funds. A reverse repurchase agreement is simply the flip side of the transaction, from the buyer’s viewpoint not the seller’s. The seller executing the transaction would describe it as a “repo,” while the buyer in the same transaction would describe it a “reverse repo.” The transaction is the same but described from opposite viewpoints. The term of the repo can be custom-tailored for any period, ranging from overnight up to a year.
The repo market originated as a means by which securities dealers could finance their bond positions, still serving this vital purpose today. Institutional investors can generally earn better short-term yields by investing their idle cash in the repo market than they can by investing in bank deposits or money market instruments.
The outstanding volume of repos and reverse repos is enormous — in excess of $4.83 trillion on an average daily basis in the third quarter of 2010 among primary dealers in U.S. government securities alone. Securities firms, commercial banks, corporations, pension funds, state and local governments, and mutual and money market funds use the repo market as a safe haven for cash investment and as a flexible alternative to bank deposits and money market instruments such as CDs and commercial paper. In the United States, repos are typically done in conjunction with U.S. Treasury bonds, mortgage securities, corporate bonds or other forms of debt agreed upon by the counterparties to the agreement.
Bonds are not only a way to invest and earn a return on your money; they are also a way to invest in the security and infrastructure of the nation, the growth of economies, and the expansion of businesses. Regardless of who issues or invests in them, bonds play a critical role in the daily economic life of the United States, and around the world.
*Sources (listed in order of appearance):
*SIFMA Research, US Bond Market Outstanding
*SIFMA Fact Book 2009, page 53 & 54.
*SIFMA Research, US Bond Market Issuance
*SIFMA Research, US Bond Market Outstanding
*SIFMA Research, US Bond Market Outstanding
*SIFMA Research Quarterly November 2010
*MSRB Fact Book 2010
*SIFMA Corporate Bonds Investor’s Guide. Includes all non convertible debt, MTNs, and Yankee bonds, but excludes all issues with maturities of one year or less, CDs, and federal agency debt. Source: Thomson Financial as of 12/31/09.
*SIFMA Research, US Bond Market Outstanding
* SIFMA Research, U.S. Primary Dealer Financing