03 October 2017

Making Sense of Bond Market

Governments, municipalities, corporates, etc. routinely raise money by selling bonds. Bond market plays a very important role in our financial system by serving as a meeting place for those who have excess money and want to lend and those who are in need of money and want to borrow. A stable and liquid bond market is hallmark of a developed financial system.
Bond market can further be classified into primary market and secondary market. Primary markets deals with the new bond issuance by an institution seeking funding. These institutions usually have an underwriter, who helps sell these bonds in the primary market. The cost of funding that the borrowing institution will have to bear is decided in primary market. Primary market new issuance activity closely tracks market participants' expectation about the performance of the economy. New issuance volume has been seen to decline considerably if market participants are not comfortable about the prospects of the economy. Secondary market on the other hand is referred to a marketplace, where the existing bonds are traded between market participants. This is usually an Over-The-Counter (OTC) market with broker dealers and money managers trading with each other, either for themselves or on behalf of a client.
According to Bank for International Settlements, total bonds outstanding as of Mar 2012 stands at USD98.8 trillion. United States (both corporate and government) is the largest bond market accounting for 34% of the market. Sovereigns are the largest borrower in the bond market accounting for 45% of the total bond outstanding. Financial institutions play an important role of financial intermediation in the economy and actively borrow in bond markets to fulfil their role and take close second place after the sovereigns at 42% of the total outstanding. Rest of the bond outstanding is mostly accounted by other corporate issuers.
The bond again can be divided between Investment Grade and High Yield. Investment Grade bond are bonds that have a BBB- and above rating from S&P and/or Fitch and Baa3 and/or above from Moody's. These bonds have low risk of default and are generally expected to pay their coupon and principal at the required date. High Yield bond are bonds that have a BB+ and below rating from S&P and/or Fitch and/or Ba1 and below from Moody's. These bonds have a high risk of default. The cost of fund that a bond issuer has to bear is highly inversely correlated with its rating with a bond having AAA rating from S&P and/or Fitch and/or Aaa rating from Moody's being required to pay lowest cost.