Ever since the global financial crisis exploded a few years back, the bond market has been at the forefront of the media’s attention after decades of always playing second fiddle to the stock market. Be it sub-prime mortgage bonds which were tearing holes out of investment banks’ balance sheets in 2007 and 2008, or Greek sovereign bonds on the verge of default, people are finally waking up to the importance of the bond market within the global economy. But besides being the largest and most important financial market in modern capitalism, the bond market can tell us a lot about the current and future state of the economy in ways that the Dow Jones or Nasdaq could not. And despite the jargon, they are not so difficult to understand. So, without further ado, here’s all you wanted to know about the bond market, in a language you can read (which is English, a language seemingly lost to many economists).
What is a bond?
In the simplest sense, a bond is basically debt. What makes a bond different from other types of debt (say, a loan) is that a bond is tradable, just like any other security such as a stock. So for example, a company can go to a bank and get a $1 million dollar loan, or he can issue $1 million dollars’ worth of bonds (say, 1,000 bonds worth $1,000 apiece) to a potentially limitless range of investors. Bonds are generally preferred over loans as a form of debt because you can issue more of it at one go (no bank is ever going to give anyone a $10 billion loan!), and because it is generally cheaper than a loan. This is because there is less risk attached to it from the lender’s perspective. Whereas the risk of a loan defaulting is borne entirely by the bank that issued it, the risk of a bond defaulting is spread across dozens of bondholders, none of which owns the full amount of the issuance (i.e. no-one bought all those bonds). As a result, a bond will likely fetch a lower interest rate than an equivalent loan, which is clearly better for the issuer. The flip side is that bond issuance is only feasible for government and medium/large firms: a small and relatively unknown firm needs to convince dozens of investors who probably know nothing about the company to buy its bonds. Continue reading