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Bond Basics in 3 Minutes

Henry Lao, CFA®

Vice President, Investments

Summary

Although bonds are an essential part of many portfolios, not all bonds have the same degree of risk and reward. Here’s what you need to know.

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While the stock market usually overshadows the bond market, the global bond market actually has a higher market value than the stock market: In 2022, it was nearly $127 trillion, as compared to about $124.4 trillion for the global equity market.1 While bonds typically don’t get as much attention, bond market movements play a large role in financial markets because of their implications for both interest rates and lending.

 

What are bonds?

Bonds are loans given by investors to corporations and governments. A corporation or government first issues bonds to raise money before investors can purchase and trade them in a secondary market. Each bond has an expected return-of-capital date, or maturity date. At maturity, the loan amount (known as the bond’s face value) is returned to the purchaser. As payments to the purchaser (known as coupons) typically don’t change in value during the life of the bond, bonds are also called fixed-income securities.

Although they pay fixed coupons and return the face value at maturity, bonds aren’t risk-free. Credit risk, also known as default risk, depends on the bond issuer’s ability to return the initial capital and deliver the interest payments as stated. Term risk is the time left until maturity. Bonds with longer maturity dates are riskier than those with shorter maturity periods because the borrower retains the capital for longer periods of time.

 

Types of bonds

Treasury bonds (or “Treasuries”), one of the most familiar types of bonds, are issued by the U.S. government. Other types of bonds are issued by U.S. states or cities, corporations, or foreign governments:

  • Municipal bonds – Issued by U.S. cities and states.
  • Corporate bonds – Issued by companies.
  • Junk bonds – Issued by companies, but considered less creditworthy than corporate bonds.
  • Sovereign bonds – Issued by foreign governments.

Each issuer has different risks. Treasuries are typically viewed as low risk since the U.S. government can always print money to repay lenders. By assigning scores to bonds, ratings agencies exert important influence on what a borrower will have to pay in interest. For example, a company with a low credit rating might need to pay higher interest to compensate for the increased level of risk relative to Treasuries. The bond’s time to maturity impacts return.

 

Bonds and yields

Bonds that trade in a secondary market can fluctuate in value, much as stock shares. Such fluctuations likely won’t matter for investors holding bonds to maturity because interest payments remain fixed, and the face value doesn’t change. However, when bonds trade in a secondary market, their values can rise and fall based on buying and selling activity, meaning that market value can deviate from face value.

There’s an important inverse relationship between bond price and yield. Yield measures interest relative to value. There are different ways to compute yield; the simplest is to divide coupon value by current price. As bond prices fall, yields rise, and vice versa. When yields rise and fall across a wide swath of bonds or globally, the trend can have important implications for the economy and financial markets relative to lending, borrowing, and costs of servicing debt.

Understanding changes in bond values—and implications for debt—can help make sense of the economy and financial markets. As bond prices rise, yields fall; as bond prices fall, yields rise. The value of bond portfolios will likewise rise and fall. And, as yields ebb and flow, ripple effects are felt throughout financial markets.

1 Securities Industry and Financial Markets Association (SIFMA) Research, 2022 Capital Markets Fact Book, July 2022.

Mercer Advisors Inc. is the parent company of Mercer Global Advisors Inc. and is not involved with investment services. Mercer Global Advisors Inc. (“Mercer Advisors”) is registered as an investment advisor with the SEC. The firm only transacts business in states where it is properly registered or is excluded or exempted from registration requirements.

All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change. Some of the research and ratings shown in this presentation come from third parties that are not affiliated with Mercer Advisors. The information is believed to be accurate but is not guaranteed or warranted by Mercer Advisors. Content, research, tools and stock or option symbols are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. For financial planning advice specific to your circumstances, talk to a qualified professional at Mercer Advisors.

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