SUNNY SIDE OF THE STREET: ANALYSIS OF THE FINANCIAL SYSTEM & THE ECONOMY (part 33)

The Debt Markets (part A)

by

Charles Lamson

Gentlemen Prefer Bonds.

Bonds and Mortgages: The Major Debt Markets

Bonds (corporate and government) and mortgages are the major long-term financial instruments of the debt market. Small changes in interest rates can cause large changes in the prices of these instruments. The longer the term to maturity, the greater the change in price for any change in the interest rate. In an era of volatile interest rates, price changes can be dramatic and bond and mortgage markets anything but dull.

What are the characteristics that all bonds have in common? How do the federal government, government agencies, and government-sponsored enterprises affect the bond market? What are the advantages and disadvantages of bonds to firms and to investors? What is the international bond market?

The mortgage market is the largest debt market in the United States. Residual mortgages make up the largest segment of the market. What are the roles of the government and government-sponsored enterprises in the mortgage market? What are the risks of investing in mortgages?

The Bond Market

Bonds issued by deficit spending units (DSUs, firms) are bought by and sold to surplus spending units (SSUs, households) in the bond market. The issuer may be the U.S. government, an agency of the government, a state or local government, a domestic or foreign corporation, or a foreign government. Bonds are debt instruments with an original maturity greater than 10 years that are issued by private and public entities. They normally pay a fixed interest rate, the coupon rate, which is stated on the face of the bond. The principal, also called the par value or face value of the bond, is repaid in full at maturity. The coupon payments are equal to the coupon multiplied by the face value of the bond and are usually made every six months.

Two major credit-rating agencies Standard & Poor's and Moody's Investors Service, analyze and evaluate bonds and assign them to one of nine risk classes based on the probability that the issuer will fail to pay back the principal and interest in full when due. The credit-rating agencies examine the pattern of revenues and costs experienced by a firm, its degree of leverage (dependence on borrowed funds), its past history of debt redemption, and the volatility of the industry, among other things. A firm with a history of strong earnings, low leverage, and prompt debt redemption would get the higher rating from Moody's and Standard & Poor's. A firm that has experienced net losses, has rising leverage, or has missed some loan payments would be rated much lower.

Moody's and Standard & Poor's also assign ratings to municipal securities issued by state and local governments. Important factors in determining the rating include the tax base, the level of outstanding debt, the current and expected budget situation, and the growth in spending.

Bond ratings are beneficial to lenders because they help the lender determine the risk involved in purchasing a specific bond. Bonds rated below investment grade are not recommended for investment and are often referred to as high yield or junk bonds depending on one's perspective. Of course their high yield results from their riskiness.

*THE FINANCIAL SYSTEM & THE ECONOMY, 3RD ED., 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 405-406*

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