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The Bond Market: What It Is, How It Works, And Why It's Important

financial planning investments taxes economy retirement college planning

Hi, it’s Nicolle Yates for Hamilton Financial Planning. Welcome back to another installment of our Investing Basic Series! 

This month, I want to discuss something that’s very important … but often overlooked: The Bond Market. Now I know Thanksgiving is right around the corner, and we can all practically smell the turkey cooking, but before we bring out the bibs, let’s talk about bonds. 

I agree the bond market isn’t as sexy or exciting as the stock market, but it’s just as or more important. I’m going to give you a little refresher on what a bond is, let you in on how the bond market works, and why we should be paying attention to it, especially now. 

Let’s start with a refresher. First things first, a bond is different than a stock. A stock is a share in a company. When you buy stock, you become an owner of that company in proportion to how much stock you own. This entitles you, the stockholder, to a proportion of that company’s assets and earnings. 

A bond is, in essence, a loan. You, the investor, are loaning money to a borrower, usually a corporation or a government, in the hope that the recipient will pay you back at a predetermined interest rate on the agreed to bond maturation date. In other words, the bond is an IOU from a corporation/government entity to the investor. 

Bonds are considered to be a secure, steady way to earn income and hedge retirement savings against risk. It’s important to note that interest rates and bond yields are inversely related; when interest rates rise, bond prices fall, and vice versa. If you want to safeguard the agreed upon interest rate and full payout, you need to hold your bond until its set maturity date. 

Longer Term Bonds, those at 10 or more years, have a greater risk of inflation. The longer you hold onto the bond, the greater the chance inflation rates will rise; this can reduce the value of payments and cause the price of the bond to fall. In fact, your payout at the end might not be worth your original investment. 

Short Term Bonds, of 3 years or less, and Intermediate Term Bonds of 5-10 years are sufficient for most investors, including investors who are in it for the long haul. If you want more details on how bonds work, check out this article.

There are 7 Bond Categories

1. Treasury Bonds

These are bonds issued by the federal government to finance its budget deficit. These are the most secure bonds on the market because they are backed by the full faith and credit of the U.S. government. These bonds will generally yield the lowest return rate because they have the least amount of risk. But they tend to perform better than higher-yielding/riskier bonds when the market takes a downturn. 

2. Municipal Bonds

These types of bonds are issued by states, cities, public utility districts, school districts, and other local agencies. These bonds raise cash to fund various projects. The interest on these bonds is tax-free

3. Agency Bonds

These bonds are issued by federal agencies like Fannie Mae and Ginnie Mae. The yields on these bonds are typically higher than Treasury Bonds because they are not backed by the full faith and credit of the U.S. government, but the risk is still considered minimal. 

4.  Investment-Grade Corporate Bonds

These are bonds issued by corporations that have a history and are still going strong - the risk of the bond defaulting is considered slim. The yields are higher than the prior three but they do tend to underperform Treasury and Agency bonds when the market takes a downturn. 

5. High Yield Bonds

These bonds are very risky. They are issued by companies with weak balance sheets and where default is a distinct possibility. The yields have the potential of being higher … but the risk is much greater.

6. Mortgage-Backed Bonds

These are pooled mortgages on real estate properties locked in by the pledge of particular collaterized assets. These bonds are unique because Mortgage Backed Bonds don’t benefit from declining interest rates. Mortgage-Backed Bonds are subject to prepayment risk. This means their value drops when the mortgage prepayments rates increase

7. Foreign Bonds

These are bonds issued by foreign corporations and governments. The issuer promises to pay the investor back their debt in another currency. Determination of how well a Foreign Bond performs depends on the strength of the dollar in relation to the particular exchange rates throughout the payout period.

The Bond Market - Where Bonds Bought and Sold

Over the past 30 years, the bond market has been, on average, 79% larger than the stock market. 

Americans are the greatest borrowers in the world. Corporations borrow hundreds of billions of dollars each year through bonds. And the US Government issues $500 billion in new debt through bonds in a good economic year. 

When the bond market is working efficiently, it provides crucial funding that allows companies and governments to borrow money more affordably. This, in turn, creates jobs and stimulates economic growth. 

However, when the bond market is malfunctioning, lending stops and loans are called in. Read: Absolute Disaster. 

There are two types of Bond Markets: the Primary Markets and the Secondary Markets. 

1. Primary Markets

This is where the offering and sale of new bonds take place. The company or government entity initially sells their bonds to investors through a bought deal or by auction.

In a bought deal an investment bank, such as Goldman Sachs, buys the entire lot of bonds at a set price. 

In an auction, buyers bid to purchase chunks of the bonds for sale. Issuers conduct auctions to raise capital at the lowest possible rate of interest and to access investors directly. 

2. Secondary Markets

After the initial offer to primary markets, bonds then go to trade in the secondary markets. This is where ordinary investors, like you and I, can buy bonds alongside the large investors. Unlike stocks, which are traded on exchanges like the New York Stock Exchange, bonds are traded Over the Counter

This means investors engage in one-off deals with each other through informal networks of bond dealers. Bids to buy and sell bonds in the secondary market are not centralized like stock exchanges, nor are they seen by all market participants. Broker-dealers can quote different bid and ask prices to different customers, and trades aren’t publicly posted immediately upon a trade taking place.

Bonds are sold this way because there are far more bonds than stocks. GE has only one stock but more than 1000 types of bonds with different yields, maturities, and even currency denominations. Most bonds are bought by large institutional investors and the average bond trade exceeds $500,000. Conversely, the average size of a stock trade is less than $10,000. As such, trading bonds on an exchange would be overwhelmingly cumbersome and convoluted. 

Bonds are also traded much less frequently than stocks. Stock exchanges typically have a steady and large supply of buyers and sellers every day. But that high daily demand is not present in the bond market. Some bonds might not trade at all for several months - or even years. 

What’s Going On with The Bond Market Now?

Because bonds aren’t traded that frequently and the Bond Market doesn’t have a steady flow of customers on a day-to-day basis, liquidity - the ability to quickly sell an asset without affecting its price - has always been a concern of bond market participants. Liquidity wasn’t much of an issue between 2000-2007 when broker dealers increased the amount of bonds they held by 800%, making it really easy for investors to buy and sell bonds. 

Liquidity dried up in ’08. Unfortunately the broker-dealers still held large quantities of bonds. This put the broker-dealers under significant pressure. Stocks can absorb price declines; however, bonds are contracts that must be paid. 

After ’08, broker-dealers significantly reduced their inventories of bonds. Changes were made to international banking rules (Dodd-Frank and Basel III Reforms) with the intent of making the financial system safer. It is now more expensive for banks to hold inventories of bonds. 

The Federal Reserve lowered interest rates for Treasuries thereby pushing investors to buy riskier bonds to finance businesses. The Fed also bought mortgage bonds to keep mortgage rates low to support the housing sector. This caused interest rates to stay down so corporations could continue to borrow at cheap rates. 

The reasoning was to keep building momentum on an upswing and enable corporations to get cheap money for expansion and reinvestment; both of which it was projected would result in an increasing employment rate and positive overall economic growth.

Possible Ramifications Today of this Policy

There is concern that a bubble has been forming in the corporate space. A number of credible financial news outlets are worried that interest rates will go from the low rates we’ve seen for decades to zero or even negative … putting long-term, conservative, income-oriented investors at a much greater risk. And these concerns are not unwarranted. 

There is legitimate concern that we might experience the risk of a zero or even negative interest rate. As of late, the bond market has been experiencing quite a bit of volatility, something most of today’s investors have not experienced.

But, if we look back to the 1970s, interest rates were all over the place. The 1970s are considered one of the worst economic periods in U.S. history with a high unemployment rate, a high inflation rate, and the worst stock crash after the Great Depression. 

And going further back, Professor of Finance, Aswath Damodaran, compiled data at NYU’s Stern School of Business to show the 30-year Treasury bond has suffered a negative return in only 15 calendar years since 1928. In other words, out of 91 years, 76 of those years saw positive returns for 30-year Treasury bonds.

While the past is certainly no indicator of future results, it does help to show the rarity of a major collapse in the bond market. If the bond market does fall on hard times in the near future, a very likely outcome is that we’ll see a consecutive number of years of sub-par performance.           

While all of this is potentially alarming, don’t panic! Maintain your balanced portfolio and remember that you’re in this for the long haul. 

If you’re invested in bonds for diversification, stability, and to pad yourself with income, bonds can continue to serve these roles, even through market turbulence. It might be wise to adjust your expectations on how much your bonds will return each year if you have the time to weather the market volatility. If you are in retirement and don’t have the time for a market recovery, consider investing in Short and Intermediate Term (5-7 years) Bonds instead of the Long Term Bonds. 

If you would like to talk more about bonds and what’s the best strategy for you, schedule a Get Acquainted Meeting with Hamilton Financial Planning today!

Happy Thanksgiving!

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