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Understanding the Bond MarketsResearch Paper

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Financial Markets

The commercial bond market exists to meet the needs of both corporations and investors. A bond is a secured debt instrument, and a commercial one is issued by a corporate entity (Investopedia, 2016). The structure of the investment is that the debt is superordinated to equity payments, though it can be subordinated to other debt instruments. This paper will discuss the commercial bond market and the role that it plays in the U.S. and global financial system.

The commercial bond market supports a few different types of transactions. From the perspective of the bond issuer, it allows the issuer to raise capital without surrendering an equity stake. There is tremendous value in this, because there are many companies that prefer to maintain ownership control. Bonds allow them to do that. Moreover, the commercial bond market allows them to lower their cost of capital. The reason for this is that bonds are obligations that are paid out before any payments for shareholders can be made. The bond, therefore, is lower risk because its requirements must be satisfied first -- a company that barely makes enough to cover the bond payments might have nothing left over for equity shareholders.

Because bonds have lower risk than equity, the company pays out lower rates on the bonds. As such, the debt lowers the cost of capital for a company There is a trade-off, in that this leverage increases the risk for the company. It has to earn enough to make payments on its bonds or it runs the risk of default, which would render the company insolvent. Companies must therefore determine the optimal balance for their industry and their specific situation of the risk of leverage and the benefits of having a lower cost of capital (Hakansson, 1999).

There are benefits to investors as well. A bond is a less risky investment than equity because of the payment structure. Most bonds are issued by governments, however. Government bonds carry lower rates of interest, because governments have higher credit ratings, especially federal entities that can print money. As such, default risk is higher for corporations. A corporate bond must pay a higher interest rate in order to compensate for this. For the investor, there is the security of a bond but at a higher rate than is offered by government debt. Or alternately, it is a means to access corporate cash flow but without taking on the risk implied by an equity investment. Corporate bonds are often used as a relatively low-risk means of increasing the return on a bond portfolio.

These transactions hold a lot of value for American and global capital markets. The bond market overall is much larger than the equity market, trading volumes of over $800 billion per day (Sifma, 2013). Bonds lend stability to portfolios and are appropriate for more investors than equity investments. As such, there is higher demand for bonds, and within that class corporate bonds hold high demand for their ability to deliver higher returns with relative safety. They are not as safe as government bonds, but they are significantly safer than equity investments. There are exceptions, such as junk bonds, but an investment-grade corporate bond has a very large target market, which is one of the reasons why the bond market is so large.

Role of Interest Rates

The prevailing interest rates in an economy are critical to determining bond rates, along with a couple of other key factors. The rate on a corporate bond will be a combination of the risk-free rate, the risk premium as determined largely by the issuer's rating, the coupon and the time to expiry. At the core of that is the risk free rate. The risk free rate is generally the Fed funds rate, which is the rate at which the Federal Reserve lends to the banks. Alternatively, LIBOR is used, which is the London Interbank Overnight Rate. The risk free rate is essentially the baseline cost of debt, because the issuer has no risk when the issuer is the Treasury. This Fed's rate is set on the basis of the macroeconomic health of the nation, more or less. The Fed funds rate is set on the basis of supply and demand for funds. It typically varies within a target range set by the Federal Reserve. The Fed looks at macroeconomic variables -- unemployment, inflation and GDP growth in particular -- in determining what monetary policy it wishes to pursue. For instance, the present rate is very low because the Fed is pursuing expansionary monetary policy. It wants to keep the price of money low, to encourage investment (Koba, 2012).

The rate that is attached to a bond begins with this risk free rate. If Rf is higher, then the overall bond market will offer higher rates. If the rate is low, such as now, then the bond market in general will offer lower yields. This is because for the most part, a company's risk premium does not change frequently. Corporate bond issuers who are established companies will seldom see changes to their risk premiums, so the baseline determinant of the bond rates that they borrow at will be the risk free rate.

It appears today that the inflation rate is the most important determinant of the risk free rate. Of the three major macroeconomic variables that drive monetary policy, the GDP has been in a moderate growth range for a few years. The interest rate would increase if GDP increased too much, but since it has not, the rate has remained stable. Unemployment is 5.5% at present. This is low for recent history but still above the pre-2008 levels. The Fed has maintained a low interest rate as a means of spurring economic growth, perhaps to some extent with the unemployment rate in mind. But more likely, inflation is a key driver. Inflation has not materialized even with a falling unemployment rate and a moderate gain in GDP. As a consequence, the rate has not changed. If inflation had ticked upwards out of the Fed's target range, it seems quite reasonable that this would have spurred an increase in rates. Without inflation, the low rate environment has been left to persist to continue stimulating the economy to help get GDP growth higher and continue to lower unemployment.

Forecasting Interest Rates

It should be fairly easy to forecast interest rate changes, since the rates have been rangebound since Adam Smith was a wee lad. But more important, the Fed changes its rates based on cues in the macroeconomic environment. Its changes typically lag critical indicators, so when those indicators change the Fed will often give a hint in a statement that it is considering a rate change, and if those indicators (such as higher than normal inflation) persist then the rate will change. There is usually some notice given to allow markets time to adjust to the possibility of a rate change, before the rate actually changes. This is what the Fed is doing now (Randow, 2016), letting the markets know that it expects to increase rates throughout 2016. The value of the forecast is that understanding when there is a risk of a rate change, investors can make decisions based on that. The market will typically price the prediction of a change in right away, illustrating the adjustment. Investors can trade on this information and companies can make decisions about issuing debt as well.

The Federal Reserve

The Federal Reserve was created in 1913 in response to a severe banking panic in 1907. In response to that, a law was passed authorizing the government to issue currency in times of crisis, whereas to that point banks had issued currency . The central bank was then created to manage the economy, and provide greater stability to the country's financial system. In the 1930s, following the stock market crash of 1929, the Fed's powers were strengthened (Federal Reserve, 2016).

The Fed's major roles are essential to the U.S. economy. There are few different roles. First is managing the money supply and the economy overall. These roles are critical, and all major countries (and most others, too) have central banks, because of the importance of having central bank stability. The central bank manages the money supply, which can create demand, manage inflation and just generally improve economic stability. The Fed can respond to financial crises, and undertake policies that will try to pre-empt such crises from occurring. This role is essential to ensuring that there is widespread consumer and investor trust in the nation's capital markets. Furthermore, the central bank through its Treasury notes provides an additional measure of liquidity to the economy.

In addition, the Federal Reserve banks are a valuable source of economic information. Scattered around the country, they are able to gather data that is then presented in a variety of different reports. These reports provide valuable information and analysis on the state of the economy, and this information is sometimes quite detailed. It could be argued… [END OF PREVIEW]

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