Markets catering to sale and purchase of financial items such as stocks, commodities, bonds, currencies, etc. are called financial markets. While financial markets can be of various types, two of the most common financial markets are money markets and capital markets. Both these markets are used to manage liquidity and risk for companies, governments and individuals. However, they differ from each other in the risk involved (and hence the returns) and the time horizon for which an investor remains invested in these markets. Money markets are low-risk and are accessed with a short-term view, but the buying and selling of financial assets in capital markets involves higher risk and is done for a medium to long-term period. While some financial markets can be very small involving just a few participants, others like the New York Stock Exchange are very big with daily trade volumes in the order of trillions of dollars.
Capital markets, in particular, are vital to the functioning of an economy and act as proxies for a general condition of the world market. These markets are used to channel financial investments between suppliers of capital such as retail and institutional investors, and users of capital such as governments, businesses, and individuals. Capital markets are accessed in order to raise capital for long-term purposes such as mergers & acquisitions, entering into a new line of business, large government projects, etc. Capital markets typically involve issuing financial instruments like equity (stock) and debt (bond).
A bond is essentially a loan that an investor makes to corporations or governments who want to raise money. Bonds fetch investors periodic interest payments (coupons) over a fixed period of time (until maturity). At the end of maturity the investor is guaranteed his principal amount back. Maturity periods of bonds range from 3 months to 30 years. The most common long-term bond has the maturity period of 10 years.
A bond market (also called the debt market) primarily includes government issued securities and corporate debt securities. The roots of bond markets can be traced back to the Italian Renaissance, when governments compelled wealthy citizens to loan money for the financing of wars against the Ottoman Empire. In return, these citizens were paid a compensation fee as interest. In fact, even during the two world wars bond markets played a crucial role in financing military operations of various nations.
Corporations issue bonds to finance their long-term corporate operations. The largest, oldest and most developed corporate bond market is the US Dollar corporate bond market, followed by the Euro denominated corporate bonds. Corporates bonds are listed and traded in exchanges and are considered riskier than government bonds.
The biggest players in the bond markets are governments which sell debt to fund theircountries’ operations. Governments borrow/lend money from/to other governments and banks and often purchase debt from other countries if they have excess reserves of that country’s money (arising out of trade between these two countries). For instance, Japan is a major holder of US government debt. As of 2009, the size of the worldwide bond market is estimated at $82.2 trillion with US alone accounting for 44% of this market with the average daily trading volume in U.S. Treasuries was $409.8 billion in 2009. Government bonds are traded directly between two parties without the involvement of an exchange.
Price of a bond vs. the yield – Yield of a bond is the return that an investor gets on the bond and is calculated as coupon amount/price. For a bond bought at its face value, the yield is equal to the interest rate. However, just like other publicly traded securities, the prices of bonds and hence their yields change on a regular basis. The price of a bond and its yield have an inverse relationship with each other, i.e. when a bond’s price rises then its yield falls and vice versa. For example, if you buy a bond with a 10% coupon atits $1,000 par value, the yield is 10% ($100/$1,000). However, if the price goes down to $800, then the yield goes up to 12.5% because you are getting the same guaranteed $100 on an asset that is worth $800 ($100/$800). Conversely, if the bond goes up in price to $1,200, the yield shrinks to 8.33% ($100/$1,200).
The natural question that follows is why does the price of a bond change. While the issuance price of a bond is usually set at par, the actual market price depends on a number of factors including the credit worthiness of the issuer, time until maturity of the bond, the demand for a bond, and the prevailing interest rates in the economy. Bonds that have already been issued and continue to be traded in the secondary market must therefore continually readjust their prices to be in line with current interest rates.
When interest rates in an economy rise, then the prices of the bonds in the market fall. This leads to an increase in the yield of older bonds thereby making them comparable with new bonds with higher coupon (interest) rates. Similarly, when the interest rates decline, the prices of bonds goes up thereby reducing the yield on older bonds and making them comparable with new bonds that have low coupon rates.
Capital markets, especially the bond markets, play an important role in the smooth functioning and growth of an economy. In fact, the importance of bond markets (primarily the Government bond markets) can be gauged from the fact that they are the biggest source of influence in setting the long-term interest rates for the economy as a whole.
Nidhi Gupta is a Social Policy graduate from the London School of Economics and manages outreach and business development at the Takshashila Institution. She is on twitter @nidhi1902