Understanding Fixed Income Markets
- There are two primary sources of financing for corporations: debt and equity. Equity is issued in the form of stocks and provides ownership rights and variable returns. Debt, on the other hand, is typically issued in the form of a bond, provides no ownership rights and promises a fixed rate of return. In addition to corporations, national and local governments may issue bonds as well, such as U.S. savings bonds.
- Fixed income securities can be sold on either primary or secondary markets. While it may seem as though the primary market -- in which the issuing institution sells the bonds directly to the investor -- would be the more active market, it is actually secondary bond markets that tend to be more active. Additionally, it is the secondary markets that add a great degree of variability in the value of bonds. For example, an investor holding a corporate bond for which she paid $20,000 may be able to sell that bond on a secondary market for $25,000, given some change in the underlying company or interest rates. The return promised by the company remains fixed; however, the perceived value by investors increases.
- Market interest rates play an important role in the value of a bond. The higher the market interest rate, the lower the value of a bond because the opportunity cost of investing in the bond increases. For example, if interest rates are near zero when an investor purchases a bond with a 5 percent rate of return and then rise to 3 percent one year later, the attractiveness of that bond is suddenly less relative to the market interest rate.
- While it may seem as though the 5 percent bond in the previous example is still a better use of the investor's money than the 3 percent market interest rate, this is not always the case. For example, if the 5 percent bond is extremely risky and carries a 50 percent chance of default, the risk-adjusted interest rate is really closer to 2.5 percent, making it less attractive than the market's 3 percent rate. In general, the greater the risk inherent in a bond, the higher the promised rate of return must be to attract willing investors. Companies such as Moody's rate the riskiness of many bond issuers in order to assist investors in determining the rate of return they will need to take on the risk of a particular investment.
