 Personal Finance PowerPoint Presentation Bonds and Secondary Market Prepare to get financially fit by practicing personal finance Most of this information comes from Investopedia Why are most bonds traded on the secondary market over the counter, which you can find online Take a look at the references, resources, continue your research from there Chizoba Mora Updated August 31, 2020 In prior presentations, we've been looking at investment goals, investment strategies, investment tools Keeping them in mind, we're now asking Why are most bonds traded on the secondary market over the counter? Like stocks, after issuance in the primary market, bonds are traded between investors in the secondary market So it's useful to have the understanding of what it means for the secondary market A term that you might hear for both stocks and bonds When we're on the investment side of things, oftentimes we're looking for that balanced type of portfolio Part of the balancing process typically will be having some of our investments, possibly in stocks Some of the investments in the bonds On both sides, you can hear this term of the secondary market On the stock side of things, stock represents the ownership or an ownership component of a corporation And you might get that ownership component from the original issuance of the corporation In other words, if the corporation wants to generate revenue or needs capital for a project They could say take a loan out, they could issue bonds which are kind of like debt instruments Or they can issue stock, which is an equity instrument Which is going to have a kind of ownership component to it on the stock side of things However, most of the time we're not purchasing the stock directly from the issuance corporation We're going to the exchanges and we're buying stocks on the secondary market Which would mean that people that had already purchased the stock, they're already on the market They're already issued, we're now purchasing and trading, selling and purchasing from there If we go to the bond side of things, same kind of thing You might have government bonds, you might have corporate bonds If you get the bonds directly from the issuer, which is going to be the government or the corporation Then you have kind of a debt instrument, which is similar to a loan Which would be like we're loaning money to them And they're giving us a promise to repay it at the end or maturity date And typically having some interest for the use of basically the rental on the purchasing power Of the money that was given And then of course, once we have that bond, which is kind of a promise of a stream of payments Which would be the interest payments and the amount of the return of the face amount at maturity We could sell them on the secondary market, not being able to change really the interest rate In order to sell them as market rates change, but rather changing the price And therefore we typically get on the secondary market the concept of selling at a premium or a discount kind of component Okay, so however, unlike stocks, most bonds are not traded in However, unlike stocks, most bonds are not traded in the secondary market via exchanges Rather, bonds are traded over the counter OTC There are several reasons why most bonds are traded OTC But chief among them is their diversity Stocks versus bonds Before looking at the bond market, let's consider how stocks commonly trade Stocks have two primary types, common stock or preferred stock and are limited to just a few characteristics So usually when we think about these stocks, we're usually thinking about the common stocks Although we could have the preferred stocks as well The point being are these limitations on the characteristics of the stocks Let's consider primarily the common stocks here Remember that they represent in essence an ownership or claim to equity of the corporation But unlike say a partnership, if you had a partnership structure, you might have different basically partners having different claims to the equity and so on When you're looking at a corporation, we want to break it into standardized units that represent the same thing And that makes it easy for the exchanges Because if something is trading on an exchange, one stock of apple for example that sells at a certain point in time would indicate that the other stocks Since they're theoretically the same in nature are now could be valued on a market value for that same amount That's one of the big benefits of trying to break out from a corporate side of things These standardized units allowing us the more capacity to get a market value of stocks Allowing us to value them and trade them more easily on things like exchanges Bonds on the other hand each have different qualities, maturities and yields So the nature of the bond is that it's going to differ it's going to be issued when it's issued And it's going to have the terms at that point of issuance which will be dependent in part on the market conditions of that time frame It's going to have the term date is going to be whatever it was when it basically issued So the outcome of this diversity is more issuers and issues of bonds with different characteristics Which makes it difficult for bonds to be traded on exchanges So with the stocks they're all uniform in nature, the bonds are not because of the nature of how the bonds are going to be put into play That's going to make it more difficult to run the exchanges because they don't have that kind of simplified nature of them Another reason why bonds are traded over the counter is the difficulty in listing current prices Stock prices are affected by new events, the PE price earnings ratio of a company And ultimately the supply and demand of shares which are reflected in the daily stock price So the fact that these things fluctuate can be gauged and valued and traded on in the market Which is going to be seen within the stock price In contrast bond prices are affected by changing interest rates and credit ratings So since trade time between issues can last weeks or even months It is difficult to list current prices for a particular bond issue which would make it challenging to trade bonds on the stock market So what kinds of bonds are commonly traded over the counter? Most corporate bonds issued by private and public corporations are traded OTC over the counter rather than listed on exchanges Furthermore, many of the transactions involving exchange traded bonds are done through OTC over the counter Corporate bonds are issued by firms to raise capital to fund various expenditures So they are attractive to investors because they provide much higher yield than bonds issued by the government So when we're thinking about types of bonds, you've got the government bonds that you could be purchasing There's less risk but then less return due to it Corporate bonds more risk because they have more likelihood to default because they can't print money or tax But you might have very good or established government bonds or corporate bonds that still have a very limited risk They might have a higher return However, this higher yield is accompanied by higher risk Investment in corporate bonds comes primarily from pension funds, mutual funds, banks, insurance companies and individual investors So the bonds that are traded on the OTC markets vary in the degree of liquidity that they enjoy Liquidity gives investors ample opportunity to buy and sell bonds before maturity at fair prices Along this liquidity, corporate bonds traded OTC over the counter provide investors with a steady stream of income and security Because they are rated based on the credit history of the issuing firm However, these bonds are not perfect investments and they include major risks such as credit risk and call risk Credit risk can arise when an issuer is unable to maintain payments on the bond Or if a rating corporation lowers the credit rating of the issuer Call risk occurs when an issuer redeems the issue before maturity leaving the investor with less favorable investing possibilities Why OTC over the counter transactions can be seen as controversial Many analysts and pundits claim that over-the-counter OTC transactions in financial instruments, especially derivatives, increase systematic risk In particular, concerns about counterparty risk grew following the financial crisis of 2007-2009 When a credit default swap in the derivatives markets received much of the blame for massive losses in the financial sector So basically, I won't get into all of that But you've got people that are saying that those derivatives were not as transparent and so on and there's problems with the market related to them So you can dive into that in more detail, it's an interesting topic So transactions in financial markets are either organized in exchanges such as the New York Stock Exchange or NASDAQ or occur over-the-counter OTC over-the-counter trade is executed directly between two parties and is not overseen or subject to the rules of major exchanges These off-exchange trades incorporate all of the types of assets seen in exchanges including commodities, equities and debt instruments Derivatives can be made of any asset and only represent contracts based on the value of underlying financial assets Futures, contracts, forward contracts, options and swaps are all derivatives So when you think about this kind of derivative kind of component, it adds a level of kind of complexity to it to some degree We won't dive into it in too much detail here, we might go into it a little bit more detail later But once again, and if you get obviously back into some of the financial crises in the past For example, 2007 through 2009, you'll hear a lot about these terminologies with the derivatives, the futures contracts, the forward contracts So once again, the derivatives can be made of any asset and only represent contracts based on the value of underlying financial assets So futures, contracts, forward contracts, the options and swaps are all derivatives Derivatives' trading makes up a large part of global markets and is increasingly prevalent due to improvements in computing technology So the capacity for the computing technology allows more people to kind of get access to these types of things Which at the start you would think might add to more kind of volatility as people don't have as much understanding as they get more access to them But hopefully over time you would think that there's more market awareness about how all this stuff is put in place And people have more understanding and then make wiser, more informed choices, making a better market overall So the controversy over OTC transactions center on a lack of oversight and information So notice clearly when you look at the exchanges themselves Part of the reasons like that the US pulls in a lot of capital investors willing to invest in the United States is because of the exchanges Which require things like uniform reporting so people have more kind of confidence And the idea here being that if investors feel comfortable that they're investing in something they know what they're investing in They can compare and contrast different things and that's why you need some level of simplicity That's why the stocks and seeing what they're trading for adds a lot more confidence to people trying to make comparisons for different stocks Those kind of things raises the trust level which is a good thing for basically both the corporations and the investors Because the corporations have the capacity to attract more capital that way And investors have the capacity to make wise decisions and feel more comfortable investing, possibly getting access to greater returns So major exchanges have a large incentive to control and regulate trades that occur on their watch OTC traders watch out for themselves on a greater degree that said the risk of financial loss is very real on exchanges as well And there is no guarantee exchange trading is less risky than over-the-counter trading So I'm not trying to say so much that more regulation is good or bad or so on You've got to find the proper mix of regulation and people basically making their own doing the market using the market to basically make the decisions But the overall idea would be that if you can make things more transparent and more comparable Have investors have more knowledge and capacity to make comparisons That's usually a good thing for everybody involved at least in the long run So what's the bottom line? Overall OTC transactions do not have the same rules about contract enforcements as most exchanges So the risk of a party failing to live up to its contractual obligations is often called a counterparty risk Although it may sometimes be referred to as default risk While counterparty risk exists in any contract, it is perceived as a larger threat when the contracts are made over the counter