What is a bond market?
Key takeaways:
- The US bond market is 22% larger than the stock market and affects interest rates on savings accounts, CDs and mortgages, making it important for all investors to understand.
- Bonds provide regular interest payments, are less risky than stocks, and usually perform better when the economy is struggling, making them helpful for reducing risk as you get older or work toward your financial goals.
The US bond market is one of the largest financial markets in the world, 22% larger than the global stock market, yet it remains mysterious to many everyday investors. Understanding how it works is crucial because it directly affects interest rates on everything from your savings account to your mortgage and plays an important role in building a balanced investment portfolio.
| Stock Market | Bond Market | |
|---|---|---|
| What is traded? | Stocks or shares | Loans or debt securities (bonds) |
| Your Role as an Investor | You have partial ownership, or equity, in a company | You loan money to a company or government |
| How are you paid back? | If the company performs well, your shares could grow in value and you can sell them for more than you paid, generating a profit or capital gain. | You earn a fixed interest rate for a set time period, and then are paid back the total amount you purchased the bond for. |
| Risk Level | Generally higher.
If the company performs poorly, the value of your shares may fall below what you paid and you could lose money if you sell. |
Generally lower.
Regular interest payments can often be used as a source of predictable fixed income. |
| Time Horizon | Often long-term, but can be short-term | Typically medium to long-term |
| Examples | NYSE, NASDAQ | U.S. Treasury Market, Corporate Bond Market |
Overview of the bond market
The bond market is where people buy and sell IOUs. When you buy a bond, you’re loaning money to a government, corporation, or other organization. In return, they promise to pay back the full amount borrowed on a specific date (the maturity date) plus regular payments of interest.
Also known as the debt, fixed-income, and credit markets, the bond market includes two parts: one where new bonds are sold, and one where people trade old ones.
Types of bonds
While the bond market is a place where all types of loans are traded, three types of bonds are the most common and affect the whole economy.
- U.S. Treasuries opens in a new window (Treasury bills, notes, and bonds) are considered among the best options for short term investments. Bills mature in less than a year, notes in two to five years, and bonds in 20 to 30 years. These are often called “risk-free” investments because they are backed by the U.S. government.
- Municipal bonds opens in a new window fund public projects like roads, bridges, and schools. They attract investors primarily because the interest they pay is often tax-free, making a good choice for people who pay higher taxes.
- Corporate bonds opens in a new window help companies fund operations and expansion. While riskier than government bonds, investment-grade corporate bonds (those rated BBB opens in a new window opens in a new window or higher by rating agencies) are more stable than stocks and usually offer better returns.
How the bond market works
The bond market is more affected by changes in interest rates than by anything else. An interest rate is the percentage of interest relative to principal for a loan. It is either the cost for an entity to borrow money or what you earn when you save or invest. This rate is the interest you’ll pay or earn over one year. Bond values move in the opposite direction when interest rates change. When rates go up, bond prices fall, and when rates go down, bond prices rise.
When investors feel uncertain about the stock market, they often put their money into bonds, particularly U.S. Treasuries, because they are seen as a safer option. This pushes bond prices up and yields down (yield is the annual return you earn from a bond’s interest payments).
Key characteristics of bonds
Bonds from companies that also sell stocks are usually more stable. Such companies must follow government rules when they issue bonds. They are required to make regular interest payments and pay back the money they borrowed. If they don’t, they could go bankrupt. To avoid that, companies make bond payments a priority. Even if a company goes bankrupt, bondholders are paid before stockholders from whatever money is left.
Bonds are also more predictable because their terms are set ahead of time. Their values don’t change as much as stock prices, which makes them a safer choice for people who want steady income and lower risk. Bonds often perform better than stocks when the economy is struggling because they give regular payments and usually lose less value.
What bond market trends mean for your finances
Bond market trends affect you in several ways. Interest rate changes affect what you earn on savings accounts, CDs, and money market accounts. When bond prices rise, banks often increase rates on deposit accounts to remain competitive.
Many financial experts recommend buying bonds through mutual funds or ETFs opens in a new window (Exchange-traded fund) that follow a group of bonds rather than buying individual bonds. This helps spread your money across different types of bonds and usually costs less to start. As you age or approach financial goals, adding more bonds and fewer stocks is a common way to lower risk.
Learning about bonds can help you make smarter choices with your money. Speak with a qualified professional to see if adding bonds to your investments would support your financial goals.
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