What is a Bond Market?

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An Introduction to Fixed Income Investment

A bond market, also known as a fixed income market, is a financial investment market where participants buy and sell debt securities.

As of 2008, the total international bond market was believed to be worth $67 trillion. Of that, the American bond market is thought to have a total net worth of $33.5 trillion.

References to the term “bond market” usually refer to government bond markets. This is generally the case because of their size and liquidity, as well as their lack of credit risk. Additionally, due to the inverse relationship between bond valuation and interest rates, bond markets are sometimes used as an indicator of sudden changes in interest rates.

Bond Market Structure

In most countries, bond markets are decentralized. The reason for this is because, unlike stock exchanges or futures markets, no two bonds are exactly alike.

One of the consequences of this decentralized market structure is that trading in bonds can incur higher costs at the expense of less liquidity in some cases.

In their 2004 paper, Secondary Trading Costs in the Municipal Bond Market, Lawrence Harriss and Michael Piwowar concluded that, “municipal bonds are substantially more expensive than similar sized equity trades.” They argued that this difference in price is a result of the lack of transparency in the bond market.

Types of Bonds

Bond markets are divided into a number of sub categories, depending on what type of bond is being traded.

  • Corporate bonds
  • Government bonds
  • Municipal bonds

Bond Investors

Similarly, investors who use bond markets can also be divided into a number of sub-categories.

  • Instutitonal investors
  • Governments
  • Bond traders
  • Private investors

Because of the lack of liquidity in the bond market, private investors only make up a small portion of the bond market in the United States.

The Global Bond Market

In 2008, the size of the global bond market increased to $83 trillion. Of that amount, 71% consisted of domestic markets. In the United States, a quarter of the market was composed of mortgage-backed bonds. In Europe, bond prices have been significantly affected by public debt, where government spending is set to increase for the foreseeable future.

Bond Market Instability

One of the advantages of bonds over other types of market investment is that they are not subject to the same volatility as stocks or currency exchanges. Principle and interest is delivered according to a set schedule.

However, participants who buy and sell bonds before they reach maturity run a number of risks, including sudden changes in interest rates. High interest rates can depress bond prices, while low interest rates can inflate them. This is an example of how bond markets can be affected by a country’s over all economic policy.

Bond markets can also be affected by the interpretation of economic indicators. If the consensus reached by economists is uniform, there may be very little movement. However, if there is no consensus, bond prices may be significantly affected as investors attempt to interpret the data on their own. This is also compounded by the fact that the importance of economic indicators can vary depending on the stage of the business cycle.

Tracking Bond Performance

There are a number of bond indices, which exist for the purpose of managing and tracking bond portfolios. Some of the better known bond indices include the Barclays Aggregate, the Citigroup Broad Grade Investment Index and the Merrill Lynch Domestic Master.

Their long-term stability and lack of credit risk make bond markets and popular choice for cautious investors.

Sources

Bond Market Association. Oct. 31/09

NYSE Bonds press release NYSE Bonds. Oct.31/09

M&GOutstanding World Bond Market Debt Bond Market Association.Oct.31/09

Outstanding U.S. Bond Market Debt Investments – Bond Vigilantes – Are the bond vigilantes vigilant enough?, Oct.31/09

Bloomberg – Bond Vigilantes Push U.S. Treasuries Into Bear Market, Oct.31/09 

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