Bond markets, ratings, and other debt
Bond markets are huge and varied. Credit ratings, government bonds, and special features shape risk and return.
The size of bond markets
Global bond markets are worth well over 100 trillion dollars, larger than global stock markets by some measures. Major issuers include governments, government agencies, municipalities, and corporations. Most bonds trade over the counter, between dealers, rather than on exchanges.
Government bonds
US Treasury securities include bills (up to one year), notes (2 to 10 years), and bonds (20 and 30 years). They are considered among the safest assets in the world and set benchmark rates. Treasury Inflation-Protected Securities (TIPS) adjust principal with inflation, protecting real value.
Municipal bonds
Municipal bonds are issued by US states, cities, and local agencies to fund schools, roads, and other projects. Their interest is often exempt from federal income tax, so they can offer lower yields while giving investors in high tax brackets similar after-tax returns.
Credit ratings
Rating agencies, chiefly S&P Global, Moody's, and Fitch, rate the creditworthiness of bond issuers. Investment-grade bonds are rated BBB- (S&P/Fitch) or Baa3 (Moody's) and above; lower-rated bonds are high-yield or 'junk' bonds, which pay higher interest to compensate for greater default risk.
Bond features and covenants
Bonds may include features such as call provisions (allowing the issuer to repay early, usually when rates fall), convertibility (allowing conversion into shares), sinking funds (requiring gradual repayment), and covenants (restrictions protecting bondholders, such as limits on additional debt).
Floating-rate and other debt
Floating-rate notes have coupons that reset with a benchmark rate, such as SOFR (the Secured Overnight Financing Rate), which replaced LIBOR as the main US dollar benchmark by mid-2023. Other debt includes bank loans, commercial paper (short-term unsecured corporate debt), and asset-backed securities.
Default and recovery
If an issuer defaults, bondholders may recover only part of their investment through bankruptcy proceedings. Secured bonds, backed by specific collateral, and senior bonds, paid first, typically recover more than subordinated debt. Default rates rise sharply in recessions, especially for high-yield issuers.
Worked example
An investor in the 35% federal tax bracket compares a municipal bond yielding 3.5% (tax-free) with a taxable corporate bond yielding 5%. The taxable-equivalent yield of the municipal bond is 3.5% / (1 - 0.35), about 5.4%, so the municipal bond offers a higher after-tax return despite its lower stated yield.
Key takeaways
Bond markets are enormous and mostly traded over the counter. US Treasuries include bills, notes, and bonds; TIPS protect against inflation. Municipal bond interest is often federally tax-exempt. Ratings divide bonds into investment grade (BBB-/Baa3 and above) and high-yield. Features include call provisions, convertibility, sinking funds, and covenants. Floating-rate debt resets with benchmarks such as SOFR, which replaced LIBOR. Secured and senior debt recover more in default.
Flashcard
Well over 100 trillion dollars globally
Check your understanding
An investor in the 30% tax bracket considers a tax-free municipal bond yielding 3.5%. What is its taxable-equivalent yield?