What is the bond market (in plain terms)
– The bond market — also called the debt market, fixed‑income market, or credit market — is where debt securities are issued and traded. A bond is a loan a buyer (the bondholder) makes to an issuer (government, municipality, or company) in exchange for periodic interest payments (the coupon) and repayment of principal at a specified maturity date.
Key elements (definitions)
– Face value (par): the amount repaid at maturity (commonly $1,000 for corporate bonds).
– Coupon: the periodic interest payment expressed as a percent of face value.
– Maturity: when the principal is returned and the bond stops paying interest.
– Yield: the return an investor earns based on price paid and future payments (commonly discussed as yield to maturity, which assumes the bond is held to maturity and coupons are reinvested at that yield).
– Primary market: new bonds sold directly by issuers to investors (new issues).
– Secondary market: previously issued bonds that trade between investors via brokers or dealers.
Brief historical notes
– Debt instruments date back thousands of years (for example, recorded transferable debts in ancient Mesopotamia).
– Governments and chartered corporations used bonds for major projects and wars; the Bank of England was created in part to raise funds via bonds for rebuilding the navy in the 1600s.
– The U.S. issued early Treasury debt for the War of Independence and later used “Liberty Bonds” during World War I.
Main bond types
– Government (sovereign) bonds: issued by national governments. U.S. Treasuries are the largest, most liquid example and are often treated as low‑risk benchmarks.
– Municipal bonds (munis): issued by states, cities, school districts, and local authorities. Many are federally tax‑exempt and sometimes exempt at state or local levels. Common structures: general obligation (backed by taxing power) and revenue bonds (paid from specific project revenues).
– Corporate bonds: issued by companies to fund operations or growth. Categorized by credit quality:
– Investment grade: higher credit quality, lower default risk.
– High‑yield (junk) bonds: lower credit quality, higher default probability and higher yields.
– Mortgage‑backed securities (MBS) and asset‑backed securities (ABS): pools of loans (like home mortgages) packaged as tradable securities. They pay out principal and interest as underlying borrowers repay.
– Emerging‑market bonds: issued by governments or companies in developing countries; typically offer higher yields and higher political/credit and currency risks.
How bonds are priced (basic formula)
Price = sum of present values of coupon payments + present value of principal
P = sum_{t=1..n} [C / (1 + r)^t] + F / (1 + r)^n
where C = coupon payment, F = face value, r = market yield per period, n = number of periods.
Worked numeric example
– Bond details: face value F = $1,000, annual coupon rate = 5% → C = $50, maturity n = 5 years.
– Case A: market yield r = 4%
– PV of coupons = 50 * [(1 − 1/1.04^5) / 0.04] ≈ 50 * 4.4518 = $222.59
– PV of principal = 1,000 / 1.04^5 ≈ $821.93
– Price ≈ 222.59 + 821.93 = $1,044.52 → sells at a premium because coupon > market yield
– Case B: market yield r = 6%
– PV of coupons ≈
– Case B: market yield r = 6%
– PV of coupons = 50 * [(1 − 1/1.06^5) / 0.06] ≈ 50 * 4.21237 = $210.62
– PV of principal = 1,000 / 1.06^5 ≈ $747.26
– Price ≈ 210.62 + 747.26 = $957.88 → sells at a discount because coupon < market yield
Key takeaways and quick checklist
– Inverse relationship: when market yield (r) rises above the coupon rate, bond price falls (discount). When r falls below the coupon rate, bond price rises (premium).
– Steps to price a plain-vanilla bond (annual coupons):
1. Compute coupon payment C = coupon rate × face value.
2. Discount each coupon: C / (1 + r)^t and sum for t = 1 to n. Use the annuity factor [(1 − 1/(1+r)^n)/r] to speed this up.
3. Discount the principal: F / (1 + r)^n.
4. Add the two present values to get price.
– Note on yield-to-maturity (YTM): YTM is the r that solves Price = sum of discounted coupon payments + discounted principal. For a given observed market price, YTM typically requires numerical methods (financial calculator, spreadsheet RATE function) unless coupons are annual and algebraic simplification applies.
– Assumptions in the worked example: annual coupon payments, flat yield curve (same r each period), no credit/default risk, no taxes or transaction costs, and the bond is plain-vanilla (no embedded options).
Selected references
– Investopedia — Bond Market overview: https://www.investopedia.com/terms/b/bondmarket.asp
– TreasuryDirect — What are Treasury securities?: https://www.treasurydirect.gov/learn/what-are-treasury-securities
– U.S. Securities and Exchange Commission (Investor.gov) — Bonds: https://www.investor.gov/introduction-investing/investing-basics/investment-products/bonds
Educational disclaimer: This explanation is for educational purposes only and is not individualized investment advice. Verify calculations and assumptions before making investment decisions.