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What Is the Bond Market and How Does it Work?

IndianMoney.com Research Team | Posted On Thursday, April 16,2009, 04:36 PM

What Is the Bond Market and How Does it Work?

 

 

What Is the Bond Market?

Bond is a security issued by a borrower that requires the issuer to make specified payments to a holder over a particular period. Bonds are rated based on the financial status of the issuer of the bond. Bonds are known as "fixed-income" securities because the sum of income the bond will generate each year is "fixed," or set, when the bond is sold. No matter what happens or who holds the bond, it will generate accurately the same amount of money.

Big organizations such as corporations, the central government, state and local governments all need to borrow money rarely. It is extremely hard to get as much money as they need just with the promise to repay it the next day. Instead, they have to agree not only to return the amount they borrowed, but also to pay a little extra in the form of a fee or interest for the privilege of borrowing the money.

Most trading in the bond market take place over-the-counter, through organized electronic trading networks, and is composed of the primary market (through which debt securities are issued and sold by borrowers to lenders) and the secondary market (through which investors buy and sell previously issued debt securities amongst themselves). Although the stock market often commands more media attention, the bond market is really many times bigger and is vital to the ongoing operation of the public and private sector.

Bond markets in most countries remain decentralized and do not have common exchanges like stock, future and commodity markets. This has take place, in part, because no two bond issues are exactly alike, and the number of different securities outstanding is far larger.

How Does it Work?

Bond market participants are similar to participants in most financial markets and are basically either buyers (debt issuer) of funds or sellers (institution) of funds and often both, Participants include: Institutional investors, Governments, Traders, Individuals.

Because of the specificity of individual bond issues, and the need of liquidity in many smaller issues, the majority of outstanding bonds are held by institutions like pension funds, banks and mutual funds. For market participants who own a bond, collect the coupon and hold it to maturity, market volatility is unrelated; principal and interest are received according to a pre-determined schedule. But participants who purchase and sell bonds before maturity are exposed to many risks, most significantly changes in interest rates. When interest rate rises, the value of existing bonds falls, since new issues pay a higher yield. Similarly when interest rates decrease, the value of existing bonds will increase, since new issues pay a lower yield. This is the basic concept of bond market volatility: changes in bond prices are inverse to changes in interest rates. Variable interest rates are part of a country's monetary policy and bond market volatility is a response to expected monetary policy and economic changes.

Economists' views of economic indicators versus actual released data supply to market volatility. A tight consensus is usually reflected in bond prices and there is little price movement in the market after the release of "in-line" data. If the economic release varies from the consensus view the market usually undergoes rapid price movement as participants interpret the data. Uncertainty usually brings more volatility before and after an economic release. Economic releases vary in importance and impact depending on where the economy is in the business cycle.

Investment companies permit individual investors the capability to participate in the bond markets through bond funds, closed-end funds and unit investment trusts. Some companies, banks, governments, and other sovereign entities may decide to issue bonds in foreign currencies as it may appear to be more constant and predictable than their domestic currency. Issuing bonds denominated in foreign currencies also gives issuers the capacity to access investment capital available in foreign markets. The proceeds from the issuance of these bonds can be used by companies to break into foreign markets, or can be converted into the issuing company's local currency to be used on present operations.

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