According to the AI overview on a Google search, bonds are defined as debt investment products where you lend money to a government entity or company in exchange for periodic interest payments and the return of the original principal when the bond matures. A bond is in effect a contract that promises repayment in accordance with the rules that are set when the bond is issued. Bonds are often referred to as "fixed-income" investments because they provide investors with a specific income stream in the form of semi-annual interest payments. Whereas stocks are considered ownership or equity in a business entity, bonds are essentially loans, extensions of credit that often serve as a way for the issuer to finance large projects or fund operational cash flow. Bonds are normally less volatile than stocks and in most cases are significantly less risky than equities (stocks). They can help diversify an investment portfolio as well as preserve your initial investment, particularly in a declining market. Government-issued bonds are considered low risk because the issuer has the power to tax. Insofar as bonds issued by a corporation, in a corporate bankruptcy, bondholders receive payment before the corporation's shareholders.
Bonds issued by government entities provide favorable income tax treatment for the interest income generated by said securities. Interest from Treasury securities is taxable at the federal level but exempt from all state and local income taxes. In an act of reciprocation, in general, interest income from state bonds is exempt from federal income taxes.
Although considered safer than equity investments, bonds are not free of risk, even the vaunted "safest" investment in the world - U.S. Treasuries. This risk of default on bonds is normally confined to non-investment-grade corporate bonds. The global speculative-grade default rate approximated 4% in 2024, with the U.S. high-yield default rate a bit lower at 3% during the same period. Of course, these default rates can significantly increase during economic downturns (recessions). For example, the high-yield default rate hit 13.7% in 2009 during the financial crisis. Higher than expected interest rates and inflation can also pose a risk to bond valuations. The amount of value decline is contingent upon the remaining term until maturity. In a rising interest rate environment, the value of a U.S. Treasury Bond maturing in 25 years will be negatively affected much more than a Treasury Note of a like amount reaching maturity in two years.
Like every major asset class, bonds have their own subset of terms, expressions, and language. To understand how bonds function, one has to have at least a basic understanding of a handful of words associated with this type of financial instrument. When a bond is first issued it is sold at its face value, otherwise known as par value. For instance, you pay $1,000 at issuance for a bond with a par value of $1,000. Subsequent to issuance, bonds are tradable instruments and extensively traded on what is known as the Secondary Market. Since interest rates are constantly changing, bonds in this market are normally sold at a premium or at a discount to par value.
A bond sold at a premium is one sold for a price higher than its par (face) value. This occurs when the bond's coupon rate is higher than the prevailing market interest rates, making it more attractive to investors. For example, you pay $1,250 for a bond with a par value of $1,000. A bond sold at a discount is one sold for a price lower than its face value. This occurs when the bond's coupon rate is lower than the prevailing market interest rates. For example, you pay $850 for a bond with a face value of $1,000. At maturity, the investor always receives the bond's face value. There is an inverse relationship between bond yields and bond values. When yields go up, bond values go down. When yields drop, bond yields rise.
There are rating services that grade the credit-worthiness of bonds - Moody's, Standard & Poor's, and Fitch Ratings. The highest quality bonds are called "investment grade." These would include U.S. Treasuries and high-quality companies with strong balance sheets. Many institutional investors have parameters in their respective investment policies that restrict bond purchases to those of investment-grade quality. Bonds not considered investment-grade are called "high-yield" or "junk bonds." This label doesn't necessarily imply the high probability of a default. That said, investors have to be careful and mindful of the risk when chasing yield.
There are multiple factors that determine the market price of a bond. First and foremost would be the credit quality of the bond issuer. Interested buyers want to know with a certain degree of certainty that they will receive the agreed upon semi-annual interest payments along with the principal amount at maturity. The length of time until maturity is also extremely relevant. On a normal yield curve, the longer the term, the higher the interest rate. The logic involved here is that the longer the time to maturity, the higher the chances of an adverse event influencing financial conditions to the downside. The interest rate (coupon rate) affixed to the bond in comparison to the general interest rate environment will also be a factor when the market is determining valuation for a specific bond. Lastly, the perceived future rate of inflation by bond market participants will contribute to establishing valuation. Higher inflation expectations will raise yields and thus lower valuations.
The United States bond market is massive. Although the stock market gets most of the attention and glamour, the bond market is larger than the stock market. The outstanding value as of May 2025 was $55.3 trillion. This represents 40% of the $145 trillion global bond market. U.S. government securities are the biggest piece of the overall bond market, approximately 60% of all U.S. debt securities. The government borrows a lot of money - both to refinance older debt as it comes due and to fund new spending. At the end of the first quarter of 2025, $29 trillion worth of Treasuries were considered tradable, more than twice the amount of corporate bonds. An additional $6.6 trillion of U.S. government debt was not considered tradable due to the fact that it sat on the balance sheet of The Federal Reserve Bank. Besides borrowing a lot, the federal government borrows frequently. Treasury bills (maturity of one year or less) are auctioned as often as weekly. While Treasury notes (maturity of 1 - 10 years) and Treasury bonds (maturity of more than 10 years) are sold on a monthly or quarterly basis.
New Treasury securities are sold at public auctions. The Treasury announces the auction date along with the specific maturities and amount to be sold. There are both non-competitive bids and competitive bids that can be tendered. Individuals can only submit non-competitive bids. These bids are processed through the Treasury Direct website. Individual investors are guaranteed to have their bids accepted at the yield determined by the auction. There are 24-30 institutional investors that are authorized to participate in the auctions. These entities are known as Primary Dealers and are composed of large commercial banks and brokerage firms. The Primary Dealers submit competitive bids specifying the rate, yield, or discount margin they are willing to accept. The Treasury reviews the various bids and awards the securities to the winning bidders.
There are some concerning trends currently percolating in the market for U.S. Treasury securities. The average rate on all interest-bearing Treasury debt is now 3.36%. This is the highest average rate since October 2009, and more than double the most recent low (1.56% in January 2022). With a federal debt balance of $38 trillion, this translates to an annual interest expense of $1.28 trillion ($38 trillion x .0336 = $1.28 trillion). Interest expenses will soon be the largest expense item in the fiscal budget, representing 18% of all annual federal expenditures. Spoiler alert: that incredible amount will in all probability be expanding in the future. Another trend is the shift from long-dated notes and bonds to short-term Treasury bills. The demand for long-dated bonds from central banks, pension funds, life insurers, commercial banks, and individuals is in decline. This shift by the Treasury is a gamble, especially in an environment where higher inflation and higher interest rates appear to be on the horizon.
My parting thoughts are not optimistic in nature. Our bond market was fortunate to experience a 40-year bull market that started in 1981 and ran until 2022. The 30-year U.S. Treasury bond yield went from 16% in 1981 to the 1% - 2% range in 2020 -2022. Since the federal government will ultimately have to utilize inflation to meet its obscene debt obligations, I can almost detect the guttural growl of a bear coming from the bond market.
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