In order to better analyze the financial markets for investing in assets, it is important to know about bonds. When people generally talk about trading and investment, the first thing that comes to mind will be the stock market. For example, the Dow Jones Industrial Average rising and falling, or a company's stock going up and down always gets people excited. However, when you ask people about bonds, most will know very little about them. This is despite the fact that the bond market in the US is several trillion dollars larger than the US stock market. There are several reasons for this lack of knowledge about bonds. One reason could be that bonds appear uninteresting as the prices may not change as fast as stock prices and it is more difficult for most people to make a quick buck from them.
Are we affected by what is happening in the bond market as we are affected by the stock market? Yes, we sure are. If it is not so obvious in the past, the influence of the bond market on our lives are clear for all to see from the momentous events over the past weeks. The near collapse of AIG, the massive bankruptcy of Lehman Brothers and the US$700 billion bailout package for the financial sector are caused by upheavals in the fixed income market, which is the bond market. So if you think that bonds will not affect you, think again. As the topic on bonds is very wide ranging and complex, for this article, I will focus on the key characteristics of bonds and talk about treasury bonds, corporate bonds and mortgage-backed securities from the US market since US market bonds are the most influential to the world economy currently, although the bonds from Europe and Asia are catching up.
The most important way bonds affect the economy is that they raise an enormous amount of money for governments and corporations. Only when money is raised that governments can spend to build infrastructure like roads and schools and corporations are able to produce their goods and services. Based on data provided by the Securities Industry and Financial Markets Association, the outstanding bond market debt in the US as at Q3 of 2007 is valued at 29 trillion dollars, of which treasury bonds for the US government is valued at 4.4 trillion, corporate bonds is 5.7 trillion and the current spotlight in the news, mortgage backed securities is the biggest at 7 trillion. These bonds are the top three types of bonds in the US market in terms of market value.
A bond, in simple language, is an interest-bearing document sold by a government body or a corporation for the purpose of raising money. Bonds are like loans in which the buyer of the bond lends money to the bond seller, who is the borrower. The bond seller will repay the money to the buyer on a specific maturity date. On that date, the bond seller will repay the par value of the bond, which is usually $1000. The bond buyer may pay an amount less than or greater than par value to purchase the bond, usually no more than 10% of the par value. Therefore, the typical bond prices may be for example $995 for below par value or $1005 for above par value, although the prices are usually quoted in terms of percentage known as the bond's yield, which is representative of the interest rate earned by the bond buyer. The maturity date of the bond can span from 1 day to 30 years. For US bonds, there are different names used to refer to bonds of varying maturities although in general, they are still called bonds. For instance, bills are securities with maturity of 12 months or less, notes have maturity of 1 to 12 years and bonds technically refer to securities that have maturities of 12 years or more. Another key characteristic of a bond is the coupon rate, which is the stated, fixed interest payment that is received by the bond buyer. The coupon is usually paid semi annually and it is quoted as a percentage of the par value of the bond. For example, for a coupon rate of 6% of par value $1000, the bond buyer will receive $60 per year, or $30 every 6 months.
The most commonly known bond is US treasuries which are bonds issued by the US government to meet their funding requirement. These bonds are backed by the full faith and credit of the US government and are considered risk free. The US treasury market is the most active and liquid market in the world. Buying US treasury is like putting money on fixed deposit with a bank that is the US government, which is even safer than normal bank fixed deposits.
Another major type of bonds is corporate bonds issued by corporations to meet their long term funding requirements as an alternative to borrowing from the bank or issuing new stock. This is because borrowing very large amounts of money from banks may not be possible or be very costly and issuing new stock may dilute the value of existing shares. As the buyers of corporate bonds are considered the company's creditors, in the event of bankruptcy, the bondholders have priority in getting their money back over the shareholders of the company.
Mortgage-back securities, which is a hot topic in news nowadays, as its name suggests, are securities that comprise of a pool of homeowners' mortgage that is packaged and sold to investors who are the bond buyers. They are intended to raise money to provide loans for people to own houses. Mortgage-back securities have noticeable differences from conventional bonds like US treasuries or corporate bonds. When a bond buyer purchases a mortgage-backed security, he or she will receive income from the repayment of mortgage loan by homeowners. For example, when you buy a house, you repay the loan an amount monthly that comprises principle repayment and interest. This money paid will contribute to the returns received by mortgage-back securities investors.
This article has provided a brief introduction on bonds which is a topic that covers a very wide range. It is especially so with regards to mortgage-backed securities and to fully understand why they influence the problems we are seeing now is actually very complex. With a better understanding of the basics of bonds from this article, the reader is encouraged to do further research and study to understand this topic in greater detail.
Alex Wen is an investor and writer with years of experience investing in the financial markets. He enjoys writing about his passion, investing, as well as sharing excellent articles on it. To visit his blog and read more on investing and finance, go to http://www.inthestockmarket.com/main
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