Bond Markets(Bond Market Association)

8/8/2019 Bond Markets(Bond Market Association)

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the bond market a ssociation

In one wayor another,

touches thelifeofeveryAmerican

thebond market


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The Bond Market Is Vital to the American Economy.The bond market raises the capital needed to build infrastructure and housing,spur economic development, create jobs and enhance Americas competitiveness inworld markets. In one way or another, the bond market touches the life of everyAmerican. Bonds lower the cost to taxpayers of financing the public debt, reducethe cost of a home mortgage, enable corporations to obtain capital for expansionand provide financing for schools, parks, hospitals, low-income housing and amultitude of other public works that enhance the quality of life.


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A. INSURANCE COMPANIES 18%

B. MUTUAL FUNDS 15 %

C. FOREIGN 15%

D. PENSION FUNDS 12 %

E. FINANCIAL INSTITUTIONS12%

F. HOUSEHOLDS 12%

G. OTHER 16%

Who Buys Bonds and Why...Bonds are bought by thousands of institutions, including mutual funds, pensionfunds, insurance companies, commercial banks, corporations, state and local gov-ernments and international investors such as central banks. Millions of individualinvestors also buy or own bonds, either directly or through mutual funds or pen-sion plans. In general, bond investors are looking for dependable income, relativesafety and portfolio diversification. A strategy combining both bonds and stocks ina portfolio generally provides for a more stable investment performance over time

than one limited to just one or the other. Municipal bonds and Treasury securitiescan also offer significant tax advantages. More information on who buys specifictypes of bonds is included in later sections of this booklet.

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How to Interpret Fluctuations in the Bond Market...The single most important factor in understanding fluctuations in the bond mar-ket is the impact that changes in the prevailing level of interest rates have on themarket value of all outstanding bonds.

Interest rates change in response to a number of things: changes in supply anddemand of credit, Federal Reserve policy, fiscal policy, exchange rates, economicconditions, market psychology and, most important for the bond market, changes inexpectations about inflation. The public is sometimes puzzled by the fact that thebond market often reacts negatively to positive economic news. The simple expla-nation is that the bond market acts as a barometer for inflation. Higher inflation isfeared by bond investors. Because it reduces the future buying power of fixed inter-

est payments that investors will receive, inflation lowers the value of bonds. Anyeconomic development or report that raises the specter of higher rates of inflation for example, lower unemployment or higher retail sales tends to weakenbond market prices. Conversely, negative news, such as higher unemployment orweak GDP growth, reduces inflationary concerns, and bond prices tend to rise.

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Why Interest Rates Are Important to You...Bond investors, or anyone who plans to buy a home, car or major appliance oncredit, can follow the direction of interest rates by following the yield on the30-year Treasury bond in the newspaper or on TV. Widely regarded as the bell-wether of the bond market, it is analogous in some ways to the Dow Jones IndustrialAverage for the stock market.

And now, lets follow a typical family through one dayas it is affected by each part of the bond market.

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When the federal government spendsmore than it receives in tax revenues, itmust borrow to finance the deficit. TheTreasury securities market is an effi-

cient means of financing ongoing feder-al government operations at the lowestpossible cost to taxpayers. Because thesecurities carry the full-faith-and-credit backing of the U.S. govern-ment, they have long been consideredthe safest investment in the world.Maintaining that reputation for safety

and ensuring the markets liquidity andefficiency are of immense importanceto U.S. taxpayers. An increase of onlyone hundredth of one percent (.0001)in the interest rate on new U.S. govern-ment bonds could cost taxpayers hun-dreds of millions of dollars annually!

The Federal Reserve System,

through the New York Fed, uses theTreasury market to implement mone-

tary policy. In order to increase themoney supply, it buys Treasury securi-ties, injecting funds into the economyand reducing interest rates. To reduce

the money supply, it sells Treasurysecurities, taking money out of theeconomy and raising interest rates. Inthis way, the Fed attempts to manageprice inflation in the economy.

The U.S. Treasury issues its securi-ties through regularly scheduled publicauctions. Key participants in the auc-

tion process are a group of investmentfirms and banks, known as PrimaryDealers, that are obligated to bid atevery auction and to make continuousmarkets in Treasury securities. Oncethe securities are issued, PrimaryDealers provide bids and offers in thesecondary market. Dealers are aided by

brokers, who act as intermediaries ontrades between dealers. Trading vol-ume in the Treasury securities marketaverages over $200 billion a day, mak-ing it the worlds most liquid securi-

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mom and dad drive tojogging before work, dad and his friend know the u.s. government runs smoothly due to cost-efficient funding by the treasury market.


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ties market. Indeed, the liquidity andefficiency of the market help the U.S.dollar to be the worlds preeminentcurrency of exchange.

The U.S. Treasury is the largestissuer of debt securities in the world,with an estimated $3.5 trillion in mar-ketable securities currently outstand-ing. Treasury securities are bought andsold worldwide by a wide range of institutional investors includingpension funds, money market funds,

commercial banks, insurance compa-nies, corporations, state and localgovernments, securities dealers andinternational investors. Approximately5 percent of outstanding marketableTreasury securities are directly in thehands of individual investors. However,many large institutional investors, like

pension funds, mutual funds andinsurance companies, hold Treasurysecurities for the benefit of individuals.

More than 50,000 state and local gov-ernments and their agencies borrowmoney by issuing bonds to build, re-pair or improve schools, streets, high-

ways, hospitals, bridges, low-incomehousing, water and sewer systems,ports, airports and many other publicworks. Projects funded by municipalbonds have a positive impact on thesurrounding communities by creating

jobs, strengthening the infrastructurerequired to maintain a competitive

business environment and improvingthe quality of life.

Municipal issuers repay their debtsin two ways: Projects that benefit theentire community, such as schools,courthouses and municipal officebuildings, are typically funded by gen-eral obligation bonds, which are repaid

by tax revenues. Projects that benefitonly their users, such as utilities andtoll roads, are typically funded by rev-enue bonds, which are often repaidwith fees collected from people whouse the services or facilities.

When the federal income tax lawwas adopted in 1913, the interest onmunicipal bonds was excluded fromfederal taxation. As a result, municipal

bond investors are willing to acceptlower yields than they can get fromtaxable investments; and state andlocal governments can borrow at inter-est rates that are, on average, 25 to 30percent lower than would otherwisebe possible.

The municipal securities market has

a record of safety second only to thatof the U.S.Treasury securities market.Individuals investing directly orthrough mutual funds, money marketfunds and bank personal trustaccounts hold about 74 percent of the$1.3 trillion of municipal debt out-standing. Property and casualty insur-

ance companies and commercial banksare the other major investors, holdingabout 13 percent and 7 percent,respectively.

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their two children arrive at the local public school built with funds raised in the municipal bond market.work over a bridge built by tax-exempt municipal bonds.


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Corporations raise capital to financeinvestments in facilities, equipment,research, development, new technolo-gy and general business expansion.

Such investment helps create new jobsand enhance productivity, which ulti-mately improves the quality of life forall Americans. In deciding how to raisecapital for investment, corporationscan issue equity securities, borrow inthe debt markets or pursue a mix of both. The driving force behind a cor-

porations financing strategy is the needto minimize its cost of capital.

A wide variety of corporate debtsecurities are available to allow busi-nesses to match certain financingrequirements with investor needs.

By taking advantage of changing mar-ket conditions, corporate bond issuerscan realize lower borrowing costs,which in turn result in lower produc-

tion costs and help American corpora-tions compete in todays global mar-kets. Most types of debt securities offerinvestors a predictable cash flow andrate of return. They are also generallysecure investments because, as credi-tors, bondholders have a high claim onthe corporations income and assets.

At issuance, corporate bonds arepurchased by underwriters, who thenmake them available for sale toinvestors. The vast majority of corpo-rate bonds trade in an efficient over-the-counter market maintained bynational and regional bond dealers.This large liquid market is now valued

at approximately $2.0 trillion. Investorsin corporate bonds include both indi-viduals and large financial institutions.

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dad works for a company that borrowed in the corporate bond market to invest in a new plant, expand the business and make it more productive. this new plant


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While governments and corporationstypically tap the securities markets forlong-term funding needs, they mayalso need to issue debt instruments for

shorter periods to finance imports, tomeet seasonal cash-flow needs or tocreate bridge financing until condi-tions are right for longer-term debtissues. To obtain this type of short-term financing, they can turn to themoney market, which includesbankers acceptances, commercial

paper and certificates of deposit (CDs).Used primarily in trade finance,bankers acceptances are guarantees of payment that permit internationaltrade to function smoothly without therisk that goods shipped will not bepaid for or that payments will be made

for goods sold that dont meet specifi-cations. Commercial paper, typicallythe lowest-cost short-term financingfor creditworthy issuers, consists of

unsecured promissory notes, oftensupported by bank credit lines, withmaturities of up to 270 days, but gen-erally extending less than a month.Foreign corporations can issue dollar-denominated commercial paper, andmunicipalities issue tax-exempt com-mercial paper or other short-term

instruments to raise cash in anticipa-tion of tax receipts or as interimfinancing prior to a bond sale.Certificates of deposit are negotiabledebt instruments issued by banks andthrift institutions against fundsdeposited for specified periods.

The generally short maturities of

money market instruments permitfirms to be flexible in funding short-term cash needs that may fluctuate

unpredictably and to take advantageof lower interest rates that typicallyexist in the shorter maturity ranges.Additionally, the money markets effi-

ciency, liquidity and size, estimatedcurrently at $1.4 trillion, frequentlymake these instruments cost-effectivealternative funding sources relative tobank loans.

From the investors perspective,money market instruments representa liquid, low-risk investment that

generally offers a higher yield thanbank deposits. The rise in popularityof money market mutual funds, begin-ning in the early 1980s, has been amajor factor in the growth of demandfor money market instruments. Mutualfunds and other large investors are theprincipal investors in money market

instruments.

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creates more jobs and makes the company a global competitor. the firm can export its goods using the money markets to smooth the way and reduce risk.


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Mortgage securities make the dream of home ownership a reality for moreAmericans by increasing the pool of capital available for mortgage loans

and reducing the cost of a mortgage byas much as half a percent. On a 30-year $100,000 mortgage, the differ-ence between 8.5 percent and 8 per-cent would mean total savings of morethan $12,500 over the life of the mort-gage. Mortgage securities are createdby institutions that either directly orig-

inate or buy loans from mortgagelenders, pool the loans and then issuesecurities representing an interest inthe underlying loan pools. Thisprocess is sometimes referred to assecuritizing mortgages. The securitiesare bought by securities dealers andsold to investors around the world. Asthe underlying mortgage loans arepaid off by the homeowners, theinvestors receive monthly payments of interest and principal.

Before the advent of mortgage secu-rities, people in some parts of thecountry found it harder to get a mort-gage simply because local institutionshad only limited access to fundingsources. Now mortgage lenders cansell mortgage loans and use the pro-ceeds to make new mortgage loans,thereby constantly replenishing thesupply of available funds and makinghousing more affordable to all homebuyers, including lower-income homebuyers.

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Certain U.S. government agencies andgovernment-sponsored enterprises(GSEs) issue their own debt securitiesto finance activities supported by pub-

lic policy, such as home ownership,farming, small-business operations andeducation. These issuers are able toborrow at favorable rates and channelthe proceeds into programs that makecredit available to sectors of the econo-my that would not otherwise enjoysuch affordable sources of funding.

The federal agency market includesdebt securities issued by the FederalNational Mortgage Association (FannieMae); the Federal Home LoanMortgage Corporation (Freddie Mac);the Federal Farm Credit System,which includes the Farm CreditSystem Financial Assistance Corpor-

ation and the Federal AgriculturalMortgage Corporation (Farmer Mac);

the Federal Home Loan Banks; theStudent Loan Marketing Association(Sallie Mae); the College ConstructionLoan Insurance Association (Connie

Lee); the Small Business Administra-tion; and the Tennessee Valley Auth-ority, among others.

Although most agency securities donot carry the governments full-faith-and-credit guarantee, their credit qual-ity is enhanced by their government-sponsored status. With an estimated

$845 billion in debt outstanding, theagency securities market is smallerthan the Treasury market but functionswith comparable efficiency and liquid-ity due to strong investor interest andcompetition among dealers.

Investors in agency securities areprimarily institutional in nature and

include state and local governments,mutual funds, pension funds, invest-ment trusts and, increasingly, foreigninvestors.

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mom teaches at a university where attendance is up because student loans have been made affordable by the federal agency securities market. the costs


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The concept of transforming loans intosecurities has been extended in recentyears from mortgages to other types of receivables such as credit card debt,

auto loans, home equity loans, equip-ment leases, accounts receivable,small-business loans and other corpo-rate loans. Asset-backed securities arecreated by institutions that buy loansfrom lenders such as banks and autocompanies, package (or pool) theloans and then issue securities repre-

senting an interest in the underlyingpools. Thus the market provides aready source of capital to replenishfunds for lending to consumers, smallbusinesses and other borrowers. It alsogives issuers the ability to strengthen

their balance sheets by removing liabil-ities associated with carrying loanassets.

Asset-backed securities are under-

written by dealers and sold toinvestors around the world. As theloans are repaid by the borrowers, thecash flow of interest and principal ispassed on to the investors. In somecases, credit enhancements such asinsurance or letters of credit back thesecurities to make them more attrac-

tive to investors.The asset-backed securities marketis one of the fastest-growing areas of finance, with $154.0 billion of newissuance in 1996, up 42.7 percentfrom the previous years level.

Investors in asset-backed securitiesinclude pension funds, mutual funds,insurance companies, money marketfunds and financial institutions.

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Most mortgage securities are issuedand/or guaranteed by the GovernmentNational Mortgage Association (GinnieMae), an agency of the U.S. govern-

ment, or by government-sponsoredenterprises (GSEs) such as the FederalNational Mortgage Association (FannieMae) and the Federal Home LoanMortgage Corporation (Freddie Mac).Some private institutions, such as sub-sidiaries of investment banks, financialinstitutions and home builders, also

package various types of mortgagepools. The latter are known as privatelabel mortgage securities, in contrastto agency mortgage securities. Mostmortgage securities carry double-A ortriple-A credit ratings from nationallyrecognized rating agencies.

Investors in the $1.7 trillion agencymortgage securities market includeinstitutions of all sizes: corporations,commercial banks, life insurance com-panies, pension funds, trust funds,mutual funds and charitable endow-ments. In recent years, individualinvestors have also become significantpurchasers of mortgage securities.

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of the familys home mortgage and car loan were reduced because capital was made available at lower rates by the mortgage and asset-backed securities markets.


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The ability of securities firms to pricesecurities effectively and to underwriteissues of government and corporatedebt depends on their ability to finance

their holdings of these securities intheir capacities as underwriters andmarket makers. The funding markets(also sometimes called the repurchaseor securities lending markets) areessential to the smooth functioning of all the debt markets. Highly liquidmarkets in debt securities require read-

ily available funding sources. In fact,repurchase agreements (repos) are themost important source of liquidity inthe Treasury and agency securitiesmarkets. This liquidity serves to lowerthe governments cost of money andthereby saves taxpayer dollars. In addi-

tion, the Federal Reserve uses repotransactions to carry out monetarypolicy.

In a typical repo agreement, a secu-

rities dealer wishing to finance a bondposition sells the bonds to a cashinvestor while simultaneously agreeingto repurchase them at a later date foran agreed-upon price. The investorreceives a return for providing thefunds. A reverse repurchase agreementis the flip side of the transaction, with

the buyer agreeing to buy bonds andthe seller agreeing to repurchase themat a future point in time. The term of the repo can be custom-tailored forany period, ranging from overnight upto a year.

The repo market originated as ameans by which securities dealerscould finance their bond positions andit still serves this vital purpose today.Institutional investors can generallyearn better short-term yields by invest-ing their idle cash in the repo market

than they can by investing in bank deposits or money market instruments.

The outstanding volume of repos isenormous in excess of $1.7 trillion

on an average daily basis in 1996among Primary Dealers in U.S. govern-ment securities alone. Securities firms,commercial banks, corporations, pen-sion funds, state and local govern-ments, and mutual and money marketfunds use the repo market as a safehaven for cash investment and as a

flexible alternative to bank depositsand money market instruments suchas CDs and commercial paper. In theUnited States, repos are typically donein conjunction with U.S. Treasurybonds, mortgage securities, corporatebonds or other forms of debt agreedupon by the counterparties to theagreement.

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as the family sleeps, the global funding market provides investors around the world a flexible overnight investment alternative for cash.


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The Bond Market Association representssecurities firms and banks t hat und erwrite,trade and sell debt securities, both domesti-cally and internationally.

Headquarters:40 Broad StreetNew York, NY 10004-2373Telephone 212.440.9400Fax 212.440.5260www.bondmarkets.com

Washington Office:

1445 New York Avenu e, NWWashington, DC 20005-2158Telephone 202.434.8400Fax 202.434.8456

Note: All figures are estimates through the end of 1996.

d e s i g n :

t h e b a r n e t t g r o u p

/ n e w y o r k . i l l u s t r a t i o n s :

g u y b i l l o u t .


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Bond Markets(Bond Market Association)

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