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How Does the Bond Market Work?

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The U.S Stock Market seems to garner most of the attention when it comes to grabbing headlines, but what about the bond market?  The bond market is an integral component of the U.S financial system.  Here is a quick overview of how the system works.

What Is a Bond?

A bond in its simplest form is an IOU.  An issuer of a bond promises to pay the buyer their principal back at a predetermined time and pays a specific amount of interest at predetermined dates.

Who Issues Bonds?

Technically, just about anyone could issue a bond.  However, the overwhelming majority of bonds are issued by corporations and governments.

Why Issue Bonds?

Just about everyone could use capital and the government and corporations are no exception.  Companies raise capital in two ways.  One is by issuing stock and the other is by selling bonds.  When companies issue bonds, the buyer of those bonds becomes a creditor of the company.  When a company issues stock, the buyers of the stock become owners of the company.

What Is the Bond Market?

The term “Bond Market” is really a very general term.  In reality, there are many different bond markets and these markets are a bit less organized and structured than major stock markets.

A market is basically a place where buyers and sellers meet to exchange money for a product or service.  When it comes to the bond market, the product is the bond.  The process of trading bonds appears more complex, but at the roots, it is simply where buys and sellers meet,albeit electronically.

How It Works

Explaining in detail all the components of the bond market would be a bit like an engineer explaining the exact process of how an engine works, so this is a bit of a an over simplification.

The majority of bond trading is done between institutions.  As an example, a client of mine may ask me to buy them a bond.  I would then call an institution and tell them I had an order for XYZ bond.  This institution would either look for that bond from another institution or they may have this bond in their own bond inventory.  A price would be quoted for that particular bond and the investor would then choose whether or not they wanted the bond at the quoted price.  Depending on the number of bonds being bought, sometimes the price can be negotiated.

On the other hand, If a client came to me asking to sell a bond, the same process would be followed in reverse.  I would call an institution and tell them I had an XYZ bond to sell and they would either buy it for their own inventory or contact other institutions to see if someone else wanted to buy the bond.  Then, we would be quoted a price we would receive for selling the bond.

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