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Understanding The Bond Market

The international bond market is worth USD 67 trillion, half of that in the US. But understanding the bond market is difficult, as it's a decentralized market. Trading happens 'over the counter' between brokers, dealers and financial institutions, rather than being focused on an organized market like the New York Stock Exchange or NASDAQ.

The bond market is mainly a market for professionals. Only 10 percent of bonds are held by individuals in the US, and in many countries the percentage is even lower.

This means information can be hard to find, particularly on smaller issues such as corporate and municipal bonds, and high yield bonds. The government bond market is more transparent, and it is in these bonds that most individuals choose to invest.

Recognizing the forces of supply and demand is key to understanding the bond market. Supply is driven by the needs of the government and of companies for finance. For instance, the government may need to issue bonds to fund its economic stimulus packages. If it issues what investors believe to be too much, it may have to offer higher interest rates to interest them in buying the bonds.

Demand may also change as for instance pension funds need to meet their liabilities by buying bonds which will deliver a certain income. Bonds always compete with stocks as an investment, so if they are considered more attractive than stocks at a given moment, demand will increase.

Understanding the bond market also demands that investors understand fully how the market is driven by interest rates. The coupon (interest rate) on a bond is fixed according to the face value of the bond when it is first issued. When interest rates change, the bond is repriced to bring its yield in line with the market. The yield and the price move in opposite directions - to make the yield increase, the price has to be cut. That's why not all bonds represent a safe haven for investors.

The bond market doesn't just reflect what the interest rate is now, but what participants in the market think it will be in future. A good tool for understanding the bond market is the yield curve, a graph of the interest rate on different maturities of bond. This shows whether investors think interest rates are likely to increase or decrease, and by extension whether they think the economy is going to grow fast or go into decline.

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