While equities are more commonly talked about in the financial press, and many budding investment professionals and students of finance will focus on stocks, bonds are both a larger and more important part of capital markets.
The reason for this is apparent when looking at the capital structure, with secured, unsecured, and subordinate bonds making up a larger portion of the capital structure of a firm than common stocks, which are at the bottom of the pyramid. Additionally, the variety of bonds out there offer a variety of institutions to get capital (and a variety of investors to get a more reliable return on their investment) than volatile equities.
So what are the most important type of bonds? Sovereign debt, particularly American debt in the form of U.S. Treasuries, are the largest and most important part of the global debt market. To encourage investment and give a variety of options to investors, the Treasury offers a variety of bonds. Treasury Bills (T-Bills) are notes that mature in one year or less, and they are unlike Treasury notes (which mature for terms between 2 and 10 years) and Treasury bonds, which mature in 20 or 30 years. The longer the duration (in most cases), the higher the coupon payment. But T-Bills are known as “zero-coupon” bonds because they are sold at a discount and redeemed at par, without paying out interest throughout the term of the bond. T-STRIPs are another kind of U.S. bond that are zero coupon bonds sold at a discount, which are of longer duration than T-Bills (originally ten years, but the program has extended to shorter duration bonds too).
To make things even more confusing, there are also so-called TIPS, or Treasury Inflation Protected Securities, and these have maturities of 5, 10, and 30 years. These are inflation-hedged bonds pay out an interest rate tied to the Consumer Price Index (CPI), meaning their payments are variable and will go up with inflation and go down as inflation falls. These are also guaranteed, so the value of TIPS won’t fall in cases of deflation.
Treasury notes and bonds pay interest twice a year, and are sold at par. These are the most familiar kinds of bonds for equity investors, as the rates on 2-year Treasury notes, 10-year Treasury notes, and 30-year Treasury bonds are typically analyzed to determine the likelihood of a recession or the Federal Reserve changing its interest rate policy.
Below these Federal bonds, there are a variety of municipal bonds which are issued by municipalities from the state to a small government-backed agency for a variety of projects. The most common form of munis are General Obligation bonds, which are backed by the municipality’s taxing authority, much like debenture corporate bonds (more on that in a bit). There are also limited-tax general obligation muni bonds (LTGOs) that are bound by a statutory limit on tax raises, whereas unlimited GOs will need to get taxpayer approval through a vote before they can be issued.
There are a variety of short-term muni notes that are also issued, although these are not very common in capital markets. More common, especially in the last decade, have been Industrial Revenue Bonds and Build America Bonds, the latter of which were born out of the Great Recession. Both of these, unlike other kinds of muni bonds, are taxable at the Federal level (although BABs have a 35% coupon tax credit), but are taxed based on the Alternative Minimum Tax.
To make things more complicated, muni bonds are also often issued in the form of muni bond fund securities—things like ABLE, LGIP, and QTP (don’t worry about what the acronyms stand for—you’ll get vertigo trying to remember all of them!), which are collections of muni bonds designed for low-risk interest payments on an investment. Most commonly these are used with so-called 529 Plans, which are often used to pay for college but can also be used to pay for private K-12 schooling (up to $10k per student) and for apprenticeships. The tax advantages of these programs are the main appeal.
If this is all exhausting, we haven’t even got to the most complicated bond markets: corporate bonds and asset-backed securities. Corporate bonds can be short-term or long-term, with short-term commercial paper (requiring maturity in 270 days) being zero-coupon money market instruments that have the additional advantage of not needing SEC registration. This is easier for the company and offers an interest-rate correlated asset with a higher yield than Treasuries (again, in most cases) for investors.
Corporate bonds often have a lot of features that are listed on the indenture, which is just a fancy word for the description and contract between the debtor (the company issuing the bond) and the creditor (the bondholders). This will show the coupon, call features such as a call premium, call protections, make whole provisos, and so forth. Debenture corporate bonds are issued by the full faith and credit of the issuer, while guaranteed bonds are backed by the company’s parent company, mortgage bonds have a property collateral (and are likely the first to be paid before other kinds of corporate bonds), and secured bonds (collateralized by some asset).
There are many features of bonds upon issuance, but there are also issues of secondary market valuation. The most important is the so-called bond seesaw, which has the bond price at the far end, the coupon yield in the middle, the current yield to the right of that, the yield to maturity to the right of the CY, and the yield to call to the right of that.
At par, all yields are the same, but if a bond goes to a discount, the current yield will be higher than the coupon, and the YTM is higher still, with the YTC the highest. At a premium this is reversed, with the CY lower than the coupon, the YTM lower than that, and the YTC the lowest.
Finally, let’s talk a little bit about asset-backed securities (ABSs), the most infamous after 2008 are mortgage-backed securities but there are also CLOs and CDOs. What’s important to know about all of these for someone entering the financial sector—especially if you’re studying for the license exams we discussed last week—is that they are all collections of various debt obligations that are then turned into an asset that pay out interest rates to a variety of investors/creditors.
There’s much more you’ll need to study for the SIE and Series 7 exams. Repurchase agreements, aka repos, are agreements between two financial institutions (usually) for one to pay T-Bills from the other at a certain price in the future, usually used by banks to ensure they meet capital ratio requirements. There are also CDs and brokered CDs, the latter of which is marketable and can be sold/resold in capital markets. There are other aspects of bonds—they can be puttable (giving investors the option to redeem at the indenture price, which is usually at par for non-zero coupon bonds), they can have a step coupon where the interest payments rise over time, they can be term bonds (issued and mature at the same time), series bonds (mature alike), or serial bonds (which mature at regular intervals).
There is a lot of information about bonds that is new to people with an interest in the stock market, and it can be intimidating at first. However, some study makes these ideas make sense because they all relate to each other, and they all have a point—all of these features are ways of creating different slices of investments in different entities to match investors with the right risk/reward tolerance for the particular asset. The complexity and diversity of the financial industry as it has developed in America has been a big reason why the U.S. economy has become the backbone of global markets.