WHAT IS THE BOND MARKET?

Companies and Governments need funds for all sorts of reasons which include expansion, diversification, general infrastructure or social programs. The problem that large organisations face is that they often need to borrow greater sums of money than Banks can provide and the solution is to raise money by offering bonds, or other debt instruments to the market place. The bond market opens up opportunities for thousands of investors to lend a portion of capital to raise the funds required.

A bond can therefore be described as I.O.U given by a borrower (Issuer) to a lender (Investor), where both sides have a vested interest to trade. The issuer is raising capital and the investor has three possible means of returns: –

• Capital gain or loss on redemption
• The interest rate payable, known as the coupon
• Interest on interest

Bonds therefore are known as fixed income investments due to the fact that you can determine the exact amount of cash you will get back if you hold the security until maturity. Some investors buy bonds for the interest element, whilst some will trade bonds to realize a profit when they sell. Some bonds pay no interest and these are known as Zero-coupon bonds, they have no separate fixed interest payments, but instead the interest element accrues and is paid in a lump sum at maturity. Issuers like zero’s because they can utilize the money raised without paying periodic interest, investors like zero’s because they can get deep discounts on buying them.

As mentioned above Bonds are part of the fixed income family. For a more detailed description of Fixed Income, please refer to our Fixed Income Guide in the course library.

Bonds are debt functioning securities unlike stocks which are equity based. This distinction is important to remember as purchasing equity (stock) comes with certain rights whereas when purchasing debt (bonds) an investor becomes a creditor to the corporation or government. The main advantage of debt over equity is that a as a creditor you have a higher claim on assets than shareholders in case of bankruptcy. Bondholders though, do not get profits if an organisation performs well. Through this mechanism bonds are always considered less risky than equities, but this normally goes hand in hand with lower returns on your investment.

The possible risks are:

Credit Risk

The risk that the issuer will default on its payments of interest and principal on its debt. You can help manage this risk by choosing only investment-grade bonds (rated BBB or higher) or by diversifying among several issues of high-yield bonds.

Reinvestment Risk

The possibility that interest rates may have fallen by the time your investment reaches maturity. If this occurs, you may be unable to reinvest your funds at the rate of return you were accustomed to receiving. When interest rates drop, bond prices generally rise because the market is willing to pay more for a higher coupon. When interest rates rise, bond prices generally fall because the market will pay less for a lower coupon.

Inflation Risk

The possibility that the value of your investment may not grow enough to keep up with inflation, reducing your purchasing power as a result.

Liquidity risk

Possible difficulties to re-sell bond on the secondary market.

Market Risk

Yields and market value of bonds will fluctuate so that your investment, if sold prior to maturity, may be worth more or less than its original cost.

There are six issuers of bonds these are:

• Governments
• Local Governments
• Supranational Organisations
• Financial Organisations
• Corporations
• Individuals (very small)

The most common and important issuers are described on the next page.