What is the Bond Market?

Definition: Market for fixed income securities to be traded on a daily basis between buyers and sellers

Key Ideas:

  1. The bond market is currently the largest financial market by assets and daily trading volume
  2. Corporations and governments worldwide utilize this as a way to raise money
  3. Buyers and sellers exist just like in the stock market.

Putting things into perspective:

By now you’ve probably heard about the stock market. Maybe because of the dot-com bubble, or the 2008 recession, or even the infamous GME short squeeze of 2021. But what if I told you there's another market, much older, and much, MUCH larger. You guessed it, the bond market! While quite simple, the earliest forms of lending appeared over 4,000 years ago in Mesopotamia, where Hammurabi’s Code defined the price of silver and even the interest charged on silver loans. As time developed, governments started issuing debt to fund wars. For example, war bonds developed in Italian city-states as a result of incessant war in the region. Florence allowed for some of their wealthier citizens to lend money to their government for some interest. As time developed the Bank of England and The U.S. Treasury also started to issue debt to fund wars abroad.

Fast forward to today, the bond market is used by companies and governments worldwide. Now, instead of Hammurabi’s Code, the United States relies on the judgment of the Federal Reserve. Eight times a year, investors and financial enthusiasts worldwide turn their ears to Jerome Powell and listen as he announces changes in Federal monetary policy. This includes setting the interest rate, managing the money supply, and regulating financial markets. Think of it more like Powell’s Code. Interest rates set by the Federal Reserve dictate borrowing rates from the Treasury all the way down to your local banks. Increases in the Federal Reserve rate could mean higher saving rates but also higher borrowing rates.

Bonds and their issuers

Corporations use both stocks (equity) and bonds (debt) to finance their operations. Governments however, cannot just issue shares that fluctuate based on some performance measures. Instead, governments make money through taxes and tariffs, just simply printing money, or through the issuance of bonds. Here are the major types of corporate and government bonds.

Corporate

  • Investment-grade bonds
  • High-yield (Junk) bonds

Government

  • Treasury Bills
  • Treasury Notes
  • Treasury Bonds
  • Treasury Inflation-Protected Securities (TIPS)
  • Separate Trading of Registered Interest and Principal of Securities (STRIPS)

Corporations issue bonds as part of their capital structure. Debt is one of two main ways, with the other one being equity. Companies can take loans from banks just like us, or choose to issue bonds through the open market. The two main types of bonds, investment-grade and junk, are a classification based on credit rating. Just as an individual's credit score affects their ability to borrow, lower credit ratings affect a corporation's ability to borrow at favorable rates. Companies see fluctuations in their credit ratings by payment history and financial position. In the United States, we most commonly see Moody's, Standard & Poor's (S&P), and Fitch .

With regards to governments, we mainly see three different types: US Government, International Governments, and Municipalities. However, for now we will be mainly focusing on the United States' fixed income economy. The US Treasury, on behalf of our government offers a variety of bonds that differ in nature and in maturity (timeline). Treasury bills, notes, and bonds all have varying maturities, with bills being the shortest (1-12 months) to bonds being the longest (20-30 years). TIPS are a special type of bond that offers a an inflation adjusted return. When a TIPS matures, you either receive the increased, inflation-adjusted price, or the original principal. STRIPS, a type of zero-coupon bond, essentially calls for the investor to buy a bond at a discounted price. The investor could pay $600 at the time of purchase and receive $1000 principal at the end of the maturity period. Zero-coupon bonds only pay out principal at the end of the maturity period and therefore come at deeply discounted prices.

Finding you in this picture

As a retail investor, you most likely participate in the secondary market. This means you purchase existing bonds in circulation from sellers through the use of brokers or institutions that access exchanges. The primary market pertains to new issues from issuers that want to sell their debt to the open market. Just like with the stock market, the bond market’s primary market allows for the creation of brand-new debt securities.

For example, when you decide you want purchase an Apple bond through our app, practically as soon as you submit a trade, post-trade processing occurs. Silo Financial sends your trade to our clearing broker, Interactive Brokers (IBKR), who is responsible for connecting you to an exchange or market venue where there is a seller who is selling the same bond at a similar price. Congratulations! There is an ideal seller available the market and your order executes! Now, Silo would get a notice and you would get a trade confirmation.

However, the process is not complete yet. IBKR is also responsible for working with the Depository Trust & Clearing Corporation (DTCC) to clear and settle this trade. The clearing process reconciles purchases with sales of bonds. IBKR needs to verify the availability of funds, record the securities, and finally reporting the trade to the DTCC. Settlement is the actual exchange of money and bonds between parties. Corporate bonds are settled in 2 business days (T+2), while government bonds are settled in one business day (T+1). The DTCC uses a netting method which aggregates trades over the course of the day and transfers the net difference in securities at the end of the day.

Why should I buy one?

By now, we've covered the history of bonds, main types of bonds, and how the market functions as it pertains to you. Overall, the bond market plays a crucial role in monetary policy and even affects your day-to-day life even if you never buy a bond! If you'd like to dive deeper into this rabbit hole, consider reading about the below topics.