Bond Markets

A bond market is a mechanism by which bonds issued by corporations, the U.S. Treasury, federal agencies, and state and municipal governments are bought and sold. Hence, the bond market is comprised of many types of buyers and sellers of bonds. A bond is a type of loan, or IOU. Corporations and governments borrow money by issuing bonds and pledge to repay the borrowed money, called the principle, plus interest in the future. The money generated by the sale of bonds is used in many productive ways.

Corporations issue bonds to finance the construction of productive facilities, purchase new equipment, expand research, or attend to other business expenses. In 2003 General Motors issued $17.6 billion in corporate bonds mainly to firm up its pension plan. The federal government issues bonds to finance the public debt. That is, the money generated through the sale of government bonds is used to make up the difference when government spending exceeds tax receipts. Similarly, state and local governments issue bonds to finance the construction of roads and bridges, schools, hospitals, parks, and other public facilities.

The bond market in the United States is largely electronic, and most trades are made over the counter (OTC). Limited bond trading takes place on a formal bond exchange. Securities firms hire bond dealers, called underwriters, to buy large quantities of bonds directly from bond issuers—corporations or governments—in primary markets. Later these underwriters resell some of these bonds to investors in secondary markets. Institutional investors such as insurance companies, mutual funds, pension funds, financial institutions, and foreign and domestic governments dominate bond purchases in U.S. bond markets.[1] Individual investors account for a small portion of bond purchases. By 2012 the total outstanding bond market debt in the United States was $38.7 trillion, as shown in Table 9.5.[2]

Corporate bonds, also called corporates, are debt obligations of issuing companies. Bondholders receive a fixed rate of interest, often semiannually. The entire principal is also repaid to the bondholder at the bond's maturity. Interest rates on corporates are usually higher than most government securities because the risk associated with corporates is higher. Interest paid on corporates is also taxable income for the bondholder. Investment-grade corporates are less risky than the high yield bonds, often called junk bonds.

Treasury securities are the debt obligations of the U.S. Treasury. Treasury bills (T-bills) mature in one year or less, and interest is paid at maturity. Treasury notes mature in two to

Table 9.5 U.S. Outstanding Bond Market Debt, 2013

Type of Bond Amount of Bond Debt ($ trillions) Percentage of Bond Debt
Corporate bonds 9.3 23.9
U.S. Treasury securities 11.3 29.2
Municipal securities 3.7 9.6
Federal agency securities 2.1 5.4
Mortgage-related securities 8.1 21.1
Money market instruments and assetbacked securities 4.2 10.8
Total U.S. bond debt 38.7 100.0

Source: Securities Industry and Financial Markets Association, “Outstanding Bond Market Debt,” March 7, 2013.

10 years and often offer slightly higher interest than T-bills. Treasury bonds mature in 10 to 30 years and offer higher interest than Treasury bills or notes. Interest income derived from Treasury securities is exempt from state and local taxes.

Municipal bonds, called munis, are debt obligations of cities, counties, states, or other public entities. Maturities vary. Investors buy munis despite the relatively low interest rate mainly because they are less risky than some corporate bonds and because the interest income gained from munis is exempt from most state and local taxes.

Federal agency securities are debt obligations of federal agencies and governmentsponsored enterprises (GSEs). These federal securities support mortgages (Fannie Mae, Freddie Mac), energy production (Tennessee Valley Authority), small businesses, and other programs. Maturities vary. Interest is relatively low but is higher than most U.S. Treasury securities. Interest income from federal agency securities is exempt from state and local taxes.

Mortgage securities are created by institutions that buy loans from mortgage lenders and then issue securities that represent this pool of mortgages, a process called securitization. The payments people make on their home mortgages raise the capital needed to repay investors the principle plus interest over time. The interest rate on mortgage securities is often higher than U.S. Treasury securities because the risk on mortgage securities is higher. Interest income from mortgage securities is subject to federal and state income taxes.

Money market instruments are types of short-term loans mainly in the form of certificates of deposit (CDs) and commercial paper. Governments and corporations often use money market instruments to satisfy financial obligations until additional tax receipts are collected or longer-term bills, notes, or bonds can be issued. Maturities vary, but virtually all money market securities mature in less than one year. The interest paid to investors is usually higher than prevailing interest rates on bank savings accounts.

Asset-backed securities are created by institutions that buy loans from lenders and then issue securities that represent the pool of loans—such as home mortgage loans, credit card debt, automobile loans, and student loans. The payments people make on their loans raise capital to repay the principle and make interest payments to investors over time.[3]

  • [1] Securities Industry and Financial Markets Association (SIFMA), “What You Should Know: The Role of Bonds in America,”
  • [2] SIFMA, “Outstanding U.S. Bond Market Debt, 1980 to 2013,” 2013
  • [3] SIFMA, “What You Should Know: The Role of Bonds in America,”
 
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