Bond Markets - Chains of IOUs

Credit: http://www.learnbonds.com/how-big-is-the-bond-market/

I did not even know what a bond market was till recently. Essentially, it is the market for all IOUs issued by a variety of market participants. The market is composed of issuers, intermediaries, and investors. All debt is eventually financed and priced in these markets. These includes :

1. Credit Card Debt
2. Auto Loans
3. Personal Line-of-Credits
4. Mortgages
5. Municipal bonds
6. Corporate Bonds
7. Sovereign Bonds like US treasury.

An issuer is the person who wants to borrow. In return for the money borrowed, the issues of the 'bond' promises a sequence of cash flows. The cash flows may be structured differently from issue to issue, but they all have one thing in common. The issuer will pay some premium for the money lent. This cost of borrowing is expressed as an interest rate. The interest rate is the lender's incentive to part with his money.  The lender is the investor. The intermediary is an institution that does one of several things:

1. Arranges a meeting of the issuer and the investor.
2. Restructures debt in order to intermediate for various risks.
3. Services the debt. ie. initiates, collects, follows-up etc on the loan.
4. In some cases, the intermediary will also act as an investor.

The bond aka "A promise to pay" is subject to various risks:

1. Credit Risk: The risk that the issuer becomes insolvent and cannot repay.
2. Inflation Risk: Macro-Economic conditions make the repayments less valuable.
3. Interest Risk: Future interest rates rise, making existing bonds less valuable.
4. Exchange Rate Risk: For international transactions, the changing currency rates may make the repayments less valuable.
5. Timing risk: The issuer prepays the loan, leaving the investor with a pile of cash that is no longer generating interest.

I attached the picture to record for myself the rise in dominance of mortgage backed securities over time, the turnaround after the sub-prime mortgage crisis is evident with the downward dip around 2008.