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Consumer borrowing includes credit cards, mortgages, auto loans and personal loans. In every case, the consumer is the borrower and the financial institution is the creditor. In the bond market, the relationship is the opposite. The federal government, municipalities and corporations are the borrowers and bond investors are the creditors. The main advantage of the bond market is that it provides another source of income for investors. The bond market also helps the economy.
The stock market receives a lot of attention; however, the size of the bond market -- $35 trillion as of the first quarter of 2011 -- makes it the largest securities market in the world, according to FINRA. The U.S. Treasury is the largest issuer of bonds, followed by mortgage-related bonds and corporate bonds. Bonds represent the transfer of savers to borrowers. For example, when the U.S. Treasury issues Treasury bills, it is effectively borrowing money from individual investors, institutions and foreign governments.
Advantages of the Bond Market
The bond market greases the wheels of the economy by making it possible for banks to offer mortgages to consumers. The federal government borrows money by issuing Treasuries for all sorts of infrastructure spending projects, national defense, public work initiatives and other government programs. States, municipalities and local cities issue bonds for local public spending initiatives. Corporations issue bonds to complete acquisitions, for capital expenditures projects and to sustain operations. In many cases, corporations would rather issue bonds, because they offer tax deductions on interest payments.
Advantage to Investors
From the perspective of investors, bonds offer fixed income payments and give investors another investment option besides stocks and other securities. In addition, municipal bonds are tax-free, meaning you don't pay federal income tax on interest income. In many cases, interest income is tax-exempt at the state and local level too. Professional investors use bonds as part of their investment portfolio to reduce and offset risk and generate income. Like stocks, the bonds are highly liquid, meaning you can buy and sell bonds in the open market.
There is a wealth of information available about bond issuers available to investors. Bonds receive ratings to help investors assess the risk of the issuer. Investment grade bonds are those rated as being safe investments. Standard & Poor's, one of several rating agencies, gives U.S. Treasuries a "AAA" rating, its highest rating because of the U.S. government's, "extremely strong capacity to meet financial commitments." Investors seeking a safe investment class often include Treasuries in their investment portfolio. On the downside, highly rated bonds such as Treasuries pay a lower interest rate than bonds of lower investment quality. Junk bonds represent the riskiest bond class and are rated below investment grade signifying less confidence in an issuer's ability to meet its financial commitments. As such, junk bond issuers must pay a higher interest rate to attract investors.
- savings bonds image by Stephen VanHorn from Fotolia.com