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Bonds and stocks are the most fundamental types of assets in today's financial markets. Stocks are familiar to most people, either through knowledge or participation. However, due to limited exposure and high participation barriers, many people do not have a clear understanding of bonds. The bond market is a specialized market that involves many types of instruments, various processes, and multiple strategies. Today, we will only gain a preliminary understanding of the bond market through this article.
I. Basic Overview of Bonds
Bonds are, in fact, a type of "standardized debt certificate." Similar to an IOU when we lend money in daily life, they specify terms such as maturity, interest rate, and scale. The difference is that the borrower is now a corporate entity, government, or bank, and the target audience is no longer just individuals but also investment institutions. Moreover, this "IOU" has a standardized clause design, with full public disclosure of the borrower's and creditor's information, traded in specialized trading venues such as the Shanghai Stock Exchange, and the certificate can be divided into several equal parts.
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II. Types of Bonds
Based on the issuer or financier, the types of bonds include Treasury bonds issued by the Ministry of Finance, local government bonds, financial bonds, corporate bonds, and company bonds, among others.
A more commonly used classification in the market is to divide bonds into credit bonds and interest rate bonds based on the presence of credit risk. Credit bonds, as the name implies, are bonds that carry credit risk (defaulting on repayment), issued by companies (including bonds issued by financial institutions), and come in various forms such as medium-term notes, short-term financing, ultra-short-term financing, corporate bonds, and enterprise bonds. Interest rate bonds, on the other hand, are bonds without credit risk but carry interest rate fluctuation risk, including Treasury bonds, local government bonds, and policy financial bonds.
III. External Ratings
Rating is one of the important aspects of bond information disclosure, divided into issuer ratings and issue ratings.
Issuer ratings assess the creditworthiness of the bond issuer, while issue ratings are specific to the bond in question. Interest rate bonds such as Treasury bonds and policy financial bonds do not carry credit risk and do not require credit ratings. The ratings mentioned here are for credit bonds issued by companies. The reason for conducting issuer/issue ratings for credit bonds is that when companies issue bonds, they target multiple institutional investors in the market. These institutional investors cannot fully understand the company's operations, cash flow, and profitability, so there must be a standard to reflect the company's creditworthiness and to bridge this information asymmetry as much as possible.Currently, the bond ratings in China's bond market are determined by six rating agencies: China Chengxin, China Bond Rating, Orient Gold & Credit, United Ratings, Dagong Global, and New Century. The credit rating scales for entities and debt instruments are roughly the same across different rating agencies. Generally speaking, domestic entity credit ratings are divided into three categories with nine levels: AAA, AA, A, BBB, BB, B, CCC, CC, C. Each credit rating can be fine-tuned with the symbols "+" or "-" to indicate a slightly higher or lower position within the rating, except for AAA+.
Debt instrument ratings are based on the ratings of the financing entities, with additional considerations for debt characteristics such as term, bond category, and the presence of guarantees or credit enhancements.
Although higher ratings generally indicate lower credit risk, due to the fact that all rating agencies in China, except for China Bond Rating, operate on a pay-for-service model from issuers, these agencies tend to give higher ratings in order to capture the rating market. This bias has led many financial institutions to distrust the external credit rating system and prefer to establish their own credit rating systems to assess the credit risk of bonds.
IV. Bond Market
The bond market refers to the venue for the issuance and trading of bonds. China's bond market is divided into two systems: the over-the-counter (OTC) market and the exchange market, with the latter including the Shanghai Stock Exchange and Shenzhen Stock Exchange. The OTC market encompasses the interbank bond market and the bank counter market. Among these bond markets, the interbank market is the main body of China's bond market.
(1) Interbank Bond Market.
The interbank market is a wholesale market where transactions are typically large in scale, with each transaction amounting to tens of millions or more. Consequently, it is usually participated in by institutional investors with substantial funds. Individual investors, due to limitations in capital and qualifications, are unable to participate.
Let's assume there is a public mutual fund A that intends to invest in bonds in the interbank market. It must first prepare the necessary documents according to the People's Bank of China's guidelines for market entry. After the central bank conducts a formal review of the materials to ensure their authenticity and completeness, it issues a notice of market entry permission to institution A.
The interbank bond market is an OTC market, which is different from the stock market where you can directly input the stock code and purchase price into the system, and the system will automatically find a trading counterparty for you. In the OTC market, transactions are more like buying groceries, where you need to inquire about prices and find trading counterparts by yourself. Generally, there are four ways for financial institutions to find trading counterparts in the interbank market:
1) Utilizing their own resources to directly reach transactions with well-connected financial institutions;2) By engaging specialized currency intermediaries to find trading counterparts. Currency intermediaries, in simple terms, are intermediary institutions that specialize in facilitating transactions between various financial institutions. Currently, there are five such intermediaries in the interbank market: Ping An Li Shun, Zhong Cheng Bao Jie Si, Shanghai International, Tianjin Xin Tang, and Shanghai Guo Li. Financial institutions report to the currency intermediaries the bonds they wish to purchase, the price, quantity, and other elements, and then the currency intermediaries seek out sellers in the market that meet the requirements to facilitate a transaction between the two parties.
3) By seeking trading counterparts through other financial institutions. Some institutions also act as currency intermediaries, facilitating bond trading transactions between other financial institutions.
4) By conducting transactions through market makers. A market maker is also an intermediary, but unlike currency intermediaries who can only introduce other trading counterparts, market makers have their own "inventory" and can act as trading counterparts themselves, quoting buy and sell prices. If Institution A finds the prices quoted by the market maker suitable, it can directly purchase 100 million in government bonds from the market maker. If Institution A later decides to sell, it can also approach the market maker. After finding a trading counterpart and reaching an agreement, Institution A and the trading counterpart (assumed to be Institution B) need to input the relevant information of this transaction into the trading system of the Foreign Exchange Trading Center. The trading system automatically generates settlement instructions, which are confirmed by both parties, A and B. Once confirmed, the transaction is effectively completed for them.
The subsequent work involves custody and fund settlement, which is the responsibility of the middle and back-office departments. The Central Treasury Depository (since it's government bonds being purchased) debits Institution A's bond custody account on the Central Bond Depository System (indicating an increase in A's bond holdings) and credits Institution B's bond custody account (indicating a decrease in B's bond holdings). The transfer of funds is carried out on the central bank's payment system, with the designated fund settlement banks for Institutions A and B transferring funds from A's account to B's account through the payment system. After the delivery of bonds and funds is completed, the system generates a settlement voucher as proof of the successful settlement of this bond transaction, thus truly concluding the entire bond trading process.
(II) Exchange Bond Market
Unlike the interbank market, the exchange market is a retail market. The lower entry threshold allows both individual and institutional investors to participate.
The biggest difference between the spot transactions on the exchange market's bidding system and the interbank market is that the exchange market implements a "continuous auction, centralized auction" trading method, meaning investors do not have to search for trading counterparts themselves.
1) If A wants to sell 1 million in government bonds, it only needs to upload its quote to the bidding and matching platform through a securities company. If there are institutions on the platform willing to accept A's quote, then the platform will automatically match and complete the transaction. If not, A will have to wait until the transaction is completed; if no counterpart is found, A's transaction will fail. This method of automatic matching by the exchange's platform, based on price, is known as continuous auction.
2) During a certain period, many market institutions have submitted their buy and sell applications to the exchange platform. After tallying, the platform finds that at a price of 100 yuan, 10 million in transactions will be completed, at 99 yuan there will be 9.8 million in transactions, and at 102 yuan, 9 million in transactions. To achieve a larger transaction scale, the platform will set the price at 100 yuan. This method of first concentrating all quotes, calculating the maximum trading volume, and then determining the transaction price is known as a collective auction. After A uploads the purchase order through the securities company, the subsequent process is mainly carried out by the system itself. If the order is executed, the securities company will transfer a transaction fund from A's account and debit bonds on A's securities account, indicating that A has ownership of the bonds.
In addition to continuous and collective auctions on the bidding system, the methods of spot transactions on the block trading system and the fixed income platform will be more diverse. The main ways for investors on the fixed income platform to conduct spot transactions are:1) A institution directly negotiates with other investors off-exchange and then conducts transactions on a fixed trading platform, which is similar to the interbank inquiry trading.
2) Transactions are facilitated through primary dealers (market makers). Primary dealers have their own "inventory" and can quote both buy and sell prices in the market, buying and selling simultaneously.
3) A institution posts a message on the platform stating its trading needs, such as the desire to purchase 10 million in government bonds. Other investors, upon seeing this, decide whether to contact A and trade based on their own conditions. The block trading platform is relatively more limited compared to the fixed-income platform. If A wants to buy 10 million in government bonds at a certain price, it can only post a message on the block trading platform and wait for a suitable counterparty (someone willing to sell 10 million in government bonds to A at A's price). Only by finding such a counterparty can A complete the transaction. As for the income from A's holding of the current bonds, it has been explained in the interbank market section and will not be repeated here. However, the auction matching system in the exchange market is more efficient compared to the one-on-one inquiry trading in the interbank market, and the exchange bond market is relatively more active.
V. Bond Returns
Bond returns are realized in two ways: coupon payments and capital gains. Let's illustrate with examples.
A institution purchases 100 million in government bonds, and during the holding period, it can earn interest income from these bonds. If A holds the bonds until maturity, it will receive interest calculated at the coupon rate on each interest payment date. Even if A sells the bonds during this process, A has the right to have the buyer pay the accrued interest for the period A held the bonds. This is what we commonly refer to as coupon income. If, after one month, the price of the 10-year government bonds rises, A can sell the 100 million in government bonds directly and earn the income from the price difference, which we call capital gains.
Capital gains and coupon income together constitute the main returns from financial institutions' investment in bonds. In this one-on-one inquiry trading model, the activity and turnover rate of bond trading in the interbank market are much lower than those of stock trading. Most bonds, once subscribed and held by financial institutions, will no longer appear in the market for trading. Only a few types of bonds, due to their large outstanding scale and numerous holders, make it easy to find trading counterparts, and thus their trading is more active. These bonds are what we commonly refer to as active bonds. Different bonds have different trading characteristics, leading to different investment strategies.