The United States bond market really consists of several different kinds of issuance. The primary issuance is the United States Treasury. The municipal bond market, the corporate bond market and more recently the derivatives market have all grown as credit demand has increased. The size of the world bond market as of 2007 was $44 trillion, and the United States market is approximately $25 trillion. Average daily transaction volume is almost $1 trillion dollars per day.
The Beginnings of the U.S. Treasury Debt Issuance
The United States Treasury bond market began as part of the funding plans for World War I. The war was financed through a rise in taxes and through the sale of war bonds, called "Liberty Bonds". Over $21 billion dollars of debt were raised in maturities that came due after the war. The budget surpluses were not enough to cover the debt and so was rolled over into bills (due in less than one year), notes (due in under ten years) and bonds (due in more than 10 years). These amounts were paid down regularly until borrowings were increased during the Great Depression.
The Changing U. S. Debt Market
Until 1929, the United States Treasury issued subscription bonds where the public signed up for a set coupon and maturity price of par. Demand for gilt edged investments became so great that the Treasury undertook auctions of notes instead. These auctions became a regular event and were important as the yields in each maturity were used to as a 'risk free rate' for credit purposes. From this point, other corporate and municipal bonds could then systematically create a yield, depending on credit considerations.
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U.S. Debt Becomes the Defacto World Currency
Foreign governments became holders of United States debt as they began to have surpluses in the balance of trade. As deficits rose during World War II and accelerated during the Vietnam war, the debt markets and the rise of debt related trading instruments has dominated financial markets. Trading of government debt is done in over-the-counter markets for the most part, as opposed to trading on a public exchange.
The Rise of Debt to Fuel the U.S. Economy
In the early 1980s, bond yields rose substantially due to increases in commodity prices, labor wage increases and expanding deficits. When the cost of living rises and bond prices decline in value, it is because competing securities have yields in excess of the additional credit risk. Bond prices anticipate rising amounts of future debt and thus yields rise. As a result, corporate credits will also rise in yield but the overwhelming amount of treasury debt will increase the riskier corporate debt faster than treasury debt.
The Use of Derivatives to Manage Risk
The rise of cheap computing power and the desire of portfolio managers to better control risk led to the development of derivative securities. Derivatives are legally created trusts that separate the corpus (the maturity payment of a bond) from the coupon stream. Thus, in periods of rising interest rates investors want their money back so as to invest at higher yields. Thus the interest-only portion rises in value. The corpus or principal amount declines because the bonds are unlikely to be called early and the yield to maturity was set (at what are now lower rates). Thus, the corpus portion must be further discounted to reach a market yield. Derivatives trading is complex as the Treasury security is often combined with other securities to form a chain of events designed to lower risk but maintain total return.