Because most bonds do not trade on exchanges, investors have less access to information about prices. The push for increased transparency has boosted interest in electronic trading platforms for bonds.
Bond market participants have become increasingly concerned about deteriorating liquidity—the ability to quickly sell an asset without affecting its price—since the financial crisis.
A record high amount of corporate debt outstanding has many wondering if there is a bubble in the corporate bond market.
As the Fed raises interest rates, many are worried that bond investors will stampede to the exits, which would drive down bond prices across the wider economy.
When it comes to finance, the stock market is the star of the show. The NYSE is one of America’s most iconic images. Newspapers and cable shows are full of discussion about IPOs and the latest information affecting the direction of stock prices. Every day you know whether it’s up or down.
Yet, over the past 25 years, the bond market has been on average 79% larger than the stock market.1 The fact is Americans borrow. We’re the biggest borrowers in the world. In a good year, the federal government issues only $500 billion in new debt through bonds. Corporations borrow hundreds of billions of dollars each year through bonds—with bond maturities ranging from a day to many years.
A well-functioning bond market provides crucial funding that allows companies and governments to borrow more affordably, creating jobs and economic growth. A malfunctioning bond market—a market in which lending suddenly ceases and loans are called in—is an absolute disaster.
This paper explains how bond markets work, what can go wrong, and why it matters for policymakers.
What is the difference between a stock and a bond?
Let’s start with the basics. A stock is an ownership stake in a company. When you buy one share of General Electric, you are a part-owner of the company. A bond is an IOU. When you buy one General Electric bond, you have loaned money to the company.
Both stocks and bonds entitle the owner (you) to cash flow from the issuer (in this case, GE). The difference is that the payments from a stock are more volatile than those from a bond. When you own GE’s stock, you receive a dividend from the company every quarter, but the company decides how much it will be each time. Most recently, GE announced that it will pay a 23-cent dividend on April 25, 2016. Ideally, the next dividend, in the third quarter, will be greater than 23 cents. However, there are no guarantees.
A bond, on the other hand, is a contract. You have agreed to lend money to a company (or country) with the stipulation that it will be paid back on a certain date and you will receive a specific, pre- determined interest payment at regular intervals for making that loan. If they don’t pay you back, they’ve violated the contract.
Each bond has three key components: The loan amount (principal), the rate of return the purchaser of the bond will receive (yield), and the date when the bond issuer will return the full amount of the bond to the investor (maturity date). A bond’s yield is based on the perceived likelihood that the issuer will be able to fulfill the contract.