Bond Market and its main categories
Bond Market is a part of the capital market. Since capital market is divided into primary and secondary market, bond market reflects that division as well. Bond market basically represents the credit or debt that the companies issue.
In the primary market, investors can apply for issue of new debt securities, the return on this would be an interest paid regularly and in the secondary market existing debt securities are traded. The aim of it is to provide long term funding or loans to the companies. The government is also an active user of the bond market. Basically, Government and corporations commonly use bonds to borrow money. This is because government has huge undertakings such as building roads, dams or funding infrastructure projects. Companies of huge size also try to grow their business, buy new property or machines and equipment for which they need a lot of capital funding. Banks typically do not provide such huge loans. And if a bank loan is opted, it would lead to loan syndication, which again would become cumbersome.
Bonds are the solution to this problem. It also provides the opportunity for the investors in the market to invest in another instrument, thus widening their portfolio. Investors can also trade in debt instruments in the secondary market, which allows them to make a gain.
Bonds are of various types. But they can be broadly divided into:
- Corporate Bonds- Just like companies can issue stock (equity), they can issue bonds as well. It is done in order to raise finance for various reasons such as expansion, new projects, ongoing projects, etc. The aim of corporate bonds is to provide long term debt, lasting at least a year. But there are short term bonds available, they are called commercial papers. Bonds with maturity less than five years are short term bonds, intermediate bonds are the bonds with maturity of five to twelve years and any bond with maturity above 10-12 years are usually long term bonds. It applies to bonds issued only by corporations. The trading of these is decentralized and dealer based. They are even listed on the stock exchanges. They usually have a fixed interest that is paid at regular intervals.
This can be further classified into Investment grade bonds which are high quality. Their yields are likely to be higher. There are also Junk bonds which are cheaper, but their yield is closely tied to the market which makes them unpredictable.
- Government Bonds- The bonds issued by the government of a country are called government bonds. These are denominated in the country’s currency. They may also be called sovereign bonds. They pay periodic interest to its holder and the face value of the bond is paid at maturity. There are three major risks associated with government bonds. The first being credit risk, because governments usually do not have profit generating activities. They usually focus on welfare of the people and infrastructure building. The second is currency risk, where the value of the currency of the country may rise and fall which may alter rates. The last risk being inflation risk since bond payout may decline over time with respect to the inflationary rates.
- Convertible Bonds- A convertible bond is a kind of debt security that has an option to be converted into a certain sum of the underlying company’s equity at particular times during the bond’s life, usually at the bond holder’s discretion. Convertible bonds are a phenomenal flexible financing option for many companies. They are particularly useful for the companies with high risk-reward expectation. Convertibles bonds are issued for a lot of reasons. By issuing convertible bonds, a company can minimize negative investor interpretation from its corporate actions.
- Mortgage Backed Bonds and Asset Backed Securities- These bonds are backed by an underlying asset. For example in case of Mortgage Backed Bond, the underlying asset may be property that has a mortgage against it and in the case of Asset Backed Security it can be a pool of various assets. This often arises due to the securitization process.
- Foreign Bonds – the bonds associated with foreign currency denominated debt. There is a promise of fixed interest payments and also to return the principal in the designated currency. This helps the issuer welcome a wide range of investors from across the globe. There is also a plus for the investor since any inflationary changes will profit him.
Bond market is a very important part of the capital market. It forms a huge and an indispensable part of it. It is three times the size of the global equity market. They are very important since they are the ones that provide cheap capital to the corporations for their ventures and eventually help in financial growth.
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