How Does the Fixed Income Market Work?

Bond trading desks in financial centers handle billions of dollars in transactions daily.

Bond trading desks in financial centers handle billions of dollars in transactions daily.

The U.S. bond market, according to Bonds Online, is more than $14 trillion in size and expected to add new issues at a rate of $10 trillion in 2013. Daily trading volume exceeds $500 billion. Municipal bonds alone account for 1.5 million different issues compared to stock issues, which number in the thousands. But Treasury, municipal and corporate bonds are not the only components of the fixed-income market. It includes preferred stocks, mortgages, money markets, syndicated loans, credit derivatives, financial futures, interest rate derivatives, convertible bonds and asset-backed securities. It is primarily a market catering to institutional investors from all over the world and is the largest financial market in existence.

Fixed-Income Trading

Fixed-income securities are traded over-the-counter between brokerage firm trading desks and institutional investors such as government central banks, commercial banks, mutual funds, investment advisers, insurance companies, corporate and municipal cash management departments, state and corporate pension funds. Small amounts of bonds are traded in the New York Stock Exchange bond room to service individual investors. Futures and some derivatives are traded on exchanges under the CME Group, which includes the CME, CBOT, NYMEX and COMEX. All fixed-income markets are regulated by the Securities and Exchange Commission and by the Financial Industry Regulatory Authority Inc., or FINRA.

Prices, Rates and Yields

Securities that fall under the fixed-income category do so because they pay a fixed annual interest payment or are derivatives of bonds — packages of securities that include futures, long and short positions in bonds. When interest rates rise, their prices fall and their yields increase. This is because their rate of interest is fixed at the coupon rate assigned at issue. When market interest rates rise, prices of fixed-income securities adjust so their annual interest payments represent a yield on the investment that is in keeping with the interest rates required by the market. The annual interest amount doesn't change but it represents a different percentage of the current market price of the bond.

Market Influences

Federal Reserve monetary policy is the main influence on the fixed-income market. When the Fed wants to spur an economic recovery out of a recession, it lowers interest rates. This drives the prices of fixed-income securities higher, thereby lowering their yields. As the economy overheats, the Fed steps in to forestall inflation by raising interest rates, and fixed-income prices fall so yields rise to keep pace with higher market rates.

Investors

Individuals represent a small portion of fixed-income investors. Individuals primarily buy fixed-income securities as savings vehicles and to provide reliable income in their retirement accounts. Corporations use fixed-income securities in maturities from overnight federal funds deposits to five-year notes as a way of managing corporate cash. Commercial banks buy fixed-income securities for their trust accounts as well as their bank cash management needs. Insurance companies use fixed-income securities to earn money on the insurance premiums paid by their clients and to fund annuities and other guaranteed income contracts. Government central banks use them to manage cash similar to commercial banks.

 

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