Bonds Are Just REALLY Large Loans

The stock market gets all of the news headlines but the bond market is nearly twice as big and more important to the health of our economy. It is a good sign when the bond market is not in the news. We want it to be boring and functioning smoothly. Disruption in the bond market is what can get the economy in trouble.

Just as individuals get a mortgage to buy a house, or a car loan to buy a vehicle, or use credit cards, corporations use debt to build factories, buy inventory, and finance acquisitions. Governments use debt to build infrastructure and to pay obligations when tax revenues fluctuate. Loans help to keep the economy running efficiently.

Whenever the size of the loan is too large for a bank to handle, companies and governments go to the bond market to finance their debt. The purpose of the bond market is to enable large amounts of money to be borrowed.

The Media Rarely Talks About Bonds -- Stocks Are More Exciting

If you don’t have a job related to finance, there is little opportunity to learn about the bond market, especially since it is rarely in the news. Here are a few things to keep in mind. Like the stock market, the bond market is made up of investors trading with other investors. The original company that received the money and is responsible for paying back the money, is not involved in the day-to-day trading. The market value of bonds can fluctuate daily due to changes in inflation, interest rates, and fickleness of investors. One day investors like the bond, and the next, they like something else more.

But regardless of those day-to-day price changes, when the bond reaches its maturity date, the company who issued the bond is responsible for paying back the original amount to whomever owns the bond at that time. The legal obligation to pay back the amount due on the bond is what gives the bond market its stability.

As individuals, we all have had exposure to loans, from mortgages to credit cards. What can make the bond market confusing versus the loan market that we are familiar with, is that the terms are frequently different.

The terms above are the most common but there can be some variations. All specific terms have to be disclosed in the original offering of the bond.

Why Invest In Bonds?

The most common reason to invest in bonds is that the interest rate paid on bonds helps to protect investors from the corrosive effect of inflation. Inflation eats away at our spending power year after year. When a bond is first issued, the interest rate paid on the bond will exceed the inflation rate because investors will not want the spending value of their money to erode due to inflation. At a bare minimum, all investors should have the goal to earn returns greater than inflation.

Bond investing provides the opportunity to earn a return at or greater than inflation without the extreme volatility of the stock market. Insurance companies, banks, and pension funds usually have significant investments in bonds because they don’t want the risk of stocks but still need to beat inflation. Individual investors do the same thing.

Lower Risk, Lower Yield ... Higher Yield, Higher Risk

What are the risks of investing in bonds? Number one is not getting your principal paid back. This is why credit rating agencies are important—to provide insight on the quality of the issuer of the bond. A triple A rating is the highest quality rating a company or government can get and that lower risk results in lower borrowing costs for the company or government. The second risk is inflation. If inflation increases more than expected and exceeds the yield on the bond, then the investor’s spending power is eroded.

If you don’t need to take additional risk to reach your investment goals, bonds are the safer bet. When you buy a traditional, high-quality bond, you know the interest that will be paid each year and you know the amount of principal to be paid at maturity. Knowing the end result in advance makes the bond market boring, and provides the fuel for our economy.