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Classification of fixed-income markets

There are different ways in which fixed-income markets are classified globally: type of issuer, credit quality, maturity, currency denomination, types of coupons, and where bonds are issued and traded.

Types of issuers

Based on the type of issuers, fixed-income markets are classified into:

  • The government and quasi-government sector includes bonds issued by supranational organizations (such as World Bank), sovereign (national) government, non-sovereign (local) government and quasi-government entities formed and owned by governments.
  • The corporate sector includes bonds issued by financial and non-financial companies.
  • The structured finance sector includes bonds created through securitization. This sector grew rapidly from 2000 but shrank after the financial crisis.

Government and financial institutions are among the largest issuers of bonds, with governments’ share increasing post-financial crisis of 2008-2009 and financial institutions’ share decreasing. While most bonds are publicly traded, bank loans are significant, particularly for SMEs.

Classification based on credit quality

Based on credit rating/quality, markets are classified into:

  • Investment grade (rating of Baa3/BBB− and above)
  • High-yield (also called speculative or junk)—less than Baa3/BBB−

The distinction is important because credit ratings provide an indication of credit risk (they are not buy/sell signals). This classification is important because many institutional investors might be restricted by their mandate to invest only in investment-grade bonds while sovereign wealth funds have more leeway.

Classification based on the original maturity

Based on original maturity, bond markets are classified into:

  • The money market includes securities of original maturity of up to 1 year.
  • The capital market includes securities not included in the money market.

Classification based on currency

Bond markets are sometimes classified based on the currency denomination of the bonds issued and traded in it. Currency denomination of a bond is important because it determines which interest rates affect its value. Almost 79% of the global bonds are denominated either in US Dollars or Euro.

Classification based on types of coupons: fixed-rate bonds vs floating-rate bonds

Based on the type of coupons, bond markets are classified into fixed-rate bond markets and floating-rate bond markets.

The size of the floating-rate bond market is driven by balance sheet risk management considerations. For example, the sources of funds available to banks are often short-term in nature and their interest rates reset periodically, hence they prefer to make loans or invest in bonds whose reference interest rates change with market interest rates so that they bear little net interest rate risk. Similarly, investors demand floating-rate debt if they believe interest rates will increase in the future and so on. Principal issuers/suppliers of floating-rate debt are consumer finance companies. Corporate borrowers also issue floating-rate debt if they believe interest rates will fall.

The coupon rate on a floating-rate note is the sum of a reference rate and a fixed spread indicating the bond’s credit risk. The most popular reference rate is LIBOR, which has many variants depending on the currency denomination. LIBOR reflects the interest rate at which a panel of banks believe they could borrow unsecured funds about other banks in the interbank market. There are many alternative rates such as Euribor, Tibor (Tokyo), etc.

Classification based on geographical location

Based on the geographical location, bond markets are classified as domestic, foreign and Eurobond.

Domestic bond market vs foreign bond market

Each country has its own domestic and foreign bond markets while the Eurobond market is global. The domestic bond market contains bonds issued by a local issuer in the local currency while the foreign bond market relates to bonds issued by a foreign issuer. Domestic and foreign bond markets are subject to legal, regulatory and tax framework of the country in which they are issued.

Eurobond market

Eurobond market is subject to less strict legal and tax requirements because it spans geographical boundaries, has a greater investor base, and potentially lower funding cost.

Developed bond markets vs emerging bond markets

Markets are further classified into developed markets, those which are well-established, and emerging markets, which are in an earlier stage of development, and which are further classified into domestic currency and foreign currency bond markets. Even though the emerging bond market is smaller in size, it offers diversification benefits, and higher yields (due to higher credit risk) and has high growth prospects.

Other classifications

Other classifications of bonds include:

Inflation-linked bonds

Inflation-linked bonds, which are typically issued by the government or investment-grade corporate issuers, and their principal and/or interest payments are indexed to some measure of inflation.

Tax-exempt bonds

Tax-exempt bonds, which are bonds exempt from federal tax and the state tax of the state in which they are issued, have lower coupon rates due to tax exemption. In countries that have capital gains tax, tax-exempt bonds may also be exempt from tax on capital gains.

Fixed-income indexes

A fixed-income index is a representative portfolio of a bond sector that is used to describe a given bond market/sector and as a benchmark for performance evaluation.

For investment-grade bonds, Bloomberg Barclays Global Aggregate Bond Index is most popular, but for emerging market debt, J.P. Morgan Emerging Market Bond Index—Global is the most prominent. Another series is the FTSE Global Bond Index.

Major categories of bond investors

Major categories of bond investors include (a) central banks, (b) institutional investors, and (c) retail investors. Central banks and institutional investors typically invest directly in the bond markets while retail investors invest indirectly through fixed-income mutual funds and ETFs.

Central banks

Central banks buy and sell bonds, typically government bonds as part of open market operations, one of the monetary policy tools. They may also buy and sell bonds denominated in foreign currencies to manage the relative value of their currency and foreign reserves.

Institutional investors

Institutional investors including pension funds, endowments, insurance companies, etc. represent the largest group of fixed-income investors. Sovereign wealth funds also invest in fixed-income markets, but they have a very long investment horizon. Retail investors invest in fixed-income securities because they have stable prices and steady cash flows.

Retail investors

Institutional investors dominate the fixed-income markets due to high informational barriers and high minimum transaction costs. Further, there is considerable diversity in fixed-income securities, and they are mainly traded over the counter (OTC) rather than on established exchanges. This is why retail investors prefer indirect investment through mutual funds and ETFs.

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