How Does the Bond Market Work?

When companies borrow money from the public, which includes a plethora of financial planning, one of the easiest ways to do so is through the bond market. Unlike the stock exchanges, this is an alternative for those interested in long-term lending that is going to provide smaller returns. Nevertheless, those returns are going to be much more reliable than most other investments. So, how exactly does the bond market work and what makes it popular with the investors?

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A Greater Investment

The bond market works on the principle of loans that exceed the needed capital for the stock market. For instance, buying stocks usually involves corporations whose shares sell for amounts counted in hundreds of dollars. With bonds, however, most investments will be valued in thousands of dollars or more. This is because they do not give one any ownership rights. Instead, they are a loan which is going to be repaid at a future date with the predetermined interest.

A Hypothetical Example

Consider, for example, an investor that is purchasing a bond amounting to $15,000. Additionally, the terms of it include an annual payment for the upcoming 20 years with an additional two-percent interest. After obtaining the bond, the investor will be entitled to a perpetual debt repayment for the next two decades. Additionally, the interest rate will ensure that the time value of money is accounted for. Thus, although this return will not parallel the potential of the stock market, it will make the lending worthwhile for the investor.

Secondary Markets

Even though it is possible to earn notable profits by investing in bonds, one can further increase their yield through the secondary markets. As with any financial sphere, these are the alternative ways to network with more interested buyers. To better explain this concept, consider the following example. The aforementioned investor that obtained the $20,000 bond is considering an early sale. This often takes place when an investor is not willing to hold the value of their “loan” until its maturity date. The reason why many people do so is that they are able to sell their bond for more than it was purchased for. Consequently, they avoid the wait that must take place and simply capitalize on their potential interest immediately.

Proper Planning

Although the bond industry is nowhere near as fast-paced as the stock market, it requires a substantial amount of financial planning. First, the investor must find a company that is worthy of lending. Often times, even the governments offer bonds that will be payable in a decade or more. After finding the potential investment, the investor must do high-level accounting to determine if the purchase makes sense. Meaning, they must do a cost-to-benefit analysis that will showcase an overview of all of their opportunity costs alongside the actual price of the bond. If the investment passes this test, it may be a good idea to purchase it.

Other important factors to consider include one’s risk preference, potential inflation, as well as the overall economy. Those who learn how to navigate all of those elements, however, are likely to earn decent returns. Regardless, even those who may not be involved could benefit from a basic understanding of the bonds and their role in the financial world.

Sources:

Investopedia

AccountingTools