Bonds are debt instruments used by corporations and government entities to raise capital from businesses, government entities, nonprofits and individual investors. Investors can choose to hold bonds to maturity, receiving regular interest payments and an eventual repayment of principal, or for quicker profits they can choose to buy and sell existing bonds on a secondary bond market. The secondary market is subject to the forces of supply and demand, like any open market. Supply and demand in the bond market is influenced by factors related to the performance of bond issuers and overall economic conditions.
Premiums and Discounts
An existing bond will pay the same interest rate for its entire life. Since interest rates offered on new bonds change on a regular basis, the secondary market is full of bonds offering different interest rates. A two-year-old bond on the market may carry a 10 percent rate, for example, while a six-month-old bond on the same market pays 12 percent. Demand for bonds paying less than the prevailing interest rate plummets, and sellers are forced to sell the bond for less than its face value, or "at a discount," to bring demand back up. Demand for bonds paying higher rates jumps up, allowing bondholders to sell the bonds for more than their face value.
Changes in credit ratings can influence the demand for different companies' bonds, due to the underlying risk factors associated with credit downgrades or upgrades. A changing credit rating alters the risk/reward tradeoff for bonds, having much the same effect as changes in prevailing interest rates. Companies with lower credit ratings experience less demand for their bonds, forcing them to pay higher interest rates to compensate for the additional risk. Bond issuers with high credit ratings can sell their bonds at lower-than-market rates due to the heightened sense of security that comes with the lower risk factor. Conservative investors or investors looking for a safe hedge against greater risks often favor safer bonds with lower yields.
Corporations influence the amount of supply in the bond market by taking on new growth initiatives financed by debt. In times of overall economic prosperity, companies tend to put more ambitious and fast-acting growth plans into action, resulting in a larger number of bonds flowing into the market from sources with varying credit scores. However, when the economy takes a turn for the worse, companies may hold off on growth strategies, focusing on retrenchment and survival until the economy recovers.
The needs of federal, state and local government entities influences the overall supply of bonds in the marketplace. When government entities invest in infrastructure projects such as new roads, bridges and canals, they are likely to issue bonds to finance the projects, relying on tax income or project-related income (like bridge tolls) to pay back to debt. When state and local governments experience financial difficulties, they are less likely to take on debt, putting infrastructure projects on hold until economic conditions turn around.
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