Bond Basics and Market Structure
Bonds are debt instruments where issuers (governments, corporations) borrow capital from investors. Key components:
- Face Value: Principal amount repaid at maturity (e.g., $1,000).
- Coupon Rate: Fixed/variable interest paid semi-annually (e.g., 5% annual = $50/year).
- Maturity Date: Ranges from 1 month (T-bills) to 30 years (Treasury bonds).
Primary vs. Secondary Markets:
- Primary: New bonds issued via auctions (e.g., U.S. Treasury auctions).
- Secondary: Traded on exchanges (NYSE Bonds) or OTC, with prices inversely related to interest rates.
Types of Bonds
- Government Bonds:
- Treasuries: Considered risk-free (U.S. default probability near 0%). Yield curve dynamics (e.g., 2023 inversion signaled recession fears).
- Sovereign Bonds: Higher risk in emerging markets (e.g., Argentina’s 2001 default).
- Corporate Bonds:
- Investment-Grade: Issuers with high credit ratings (e.g., Microsoft, AAA).
- High-Yield (Junk Bonds): Higher default risk (e.g., Tesla’s 2017 bonds rated B3).
- Municipal Bonds: Tax-exempt debt for public projects (e.g., schools, highways).
Pricing, Yields, and Risks
- Bond Pricing:
- Bonds trade at premiums (above face value) or discounts (below). Example: A 10-year bond with a 5% coupon trades at $1,200 if market rates drop to 3%.
- Duration: Measures sensitivity to rate changes. A duration of 5 = 5% price drop for every 1% rate rise.
- Yield Metrics:
- Current Yield: Annual coupon / Price.
- Yield to Maturity (YTM): Total return if held to maturity, accounting for price and coupon.
- Credit Risk:
- Rating agencies (Moody’s, S&P) assess default probabilities. Downgrades (e.g., U.S. in 2011) spike borrowing costs.
- Credit Spreads: Difference between corporate and Treasury yields reflects risk (e.g., 2023 spreads widened during banking crises).
Strategic Role in Portfolios
- Capital Preservation: Short-term bonds (T-bills) protect principal during market downturns.
- Income Generation: Retirees often rely on coupon payments.
- Diversification: Bonds typically have negative correlation with equities.
- 60/40 Portfolio: 60% stocks, 40% bonds historically reduced volatility while delivering ~7–9% annual returns.
- Laddering Strategy: Buying bonds with staggered maturities ensures liquidity and rate flexibility.
Case Study: During the 2008 crisis, U.S. Treasuries surged as equities collapsed, proving their “flight to safety” role.
