Bonds

Bonds

Bonds are debt instruments. When you buy a bond, you are lending money to a corporation or a government entity. You receive a steady interest payment in return for as long as you hold the bond. If you hold the bond to maturity, you receive the face value of the bond at the expiration. If you sell the bond in the open market, it may be worth more or less than face value, depending on the current interest rate of comparable bonds.

1. Bonds are debt instruments.
2. Governments and large corporations issue bonds as a way of borrowing money from a broader range of people and institutions than just banks.
3. When you buy a bond, you are lending money to that government entity or that corporation. You receive a steady interest payment in return for as long as you hold the bond. If you hold the bond to maturity, you receive the face value of the bond at the expiration. If you sell the bond in the open market, it may be worth more or less than face value, depending on the current interest rate of comparable bonds.
4. Any owner of government bonds… can collect the interest at his convenience in several different places without any effort.
5. Example:
   1. Japanese government ten-year bonds with a face value of 100,000 yen and a fixed interest rate or “coupon” of 1.5%.
   2. This is just a tiny part of the vast (trillions of yen) mountain of public debt that Japan has accumulated.
   3. The bond embodies a promise by the Japanese government to pay 1.5% of 100,000 yen every year for the next ten years to whoever owns the bond.
   4. The initial purchaser of the bond has the right to sell it whenever he likes at whatever price the market sets.
   5. At any time, the bond market sets the prices for the bonds.
6. From the modest beginnings (some 800 years ago), the market for bonds has grown to a vast size (trillions and trillions).
7. All of us, whether we like it or not (and most of us do not even know it), are affected by the bond market in two important ways.
   1. retirement money ends up being invested in the bond market
   2. the bond market sets long-term interest rates for the economy as a whole.

Bond market and interest rates

1. Because of its huge size, and because big governments are regarded as the most reliable of borrowers, it is the bond market that sets long-term interest rates for the economy as a whole.
2. When bond prices fall, interest rates soar, with painful consequences for all borrowers.
3. This is how it works.
   1. Someone has 100,000 yen they wish to save.
   2. Buying a 100,000 yen bond keeps the capital sum safe while also providing regular payments to the saver.
   3. The bond pays a fixed rate or coupon of 1.5%: 1,500 yen a year in the case of a 100,000 yen bond.
   4. But the market interest rate or current yield is calculated by dividing the coupon by the market price. Assume that it is 102,333 yen: 1,500/102,333 = 1.47%.
   5. The current yield should not be confused with the yield to maturity, which takes account of the amount of time before the bond is redeemed at par by the issuing government.
   6. Now imagine a scenario in which the bond market took freight at the huge size of the Japanese government’s debt. Suppose the investors began to worry that Japan might be unable to meet the annual payments to which it had committed itself. Or suppose they began to worry about the health of the Japanese currency, the yen, in which bonds are denominated and in which the interest is paid.
   7. In such circumstances, the price of the bond would drop as nervous investors sell off their holdings. Buyers would only be found at a price low enough to compensate them for the increased risk of a Japanese default or currency depreciation.
   8. Let us imagine the price of our bond fell to 80,000. Then the yield would be 1,500/80,000 = 1.88%.
   9. At a stroke, long-term interest rates for the Japanese economy as a whole would have jumped by just over two fifths of 1%, from 1.47% to 1.88%
   10. People who had invested in bonds for their retirement before the market move would be 22% worse off, since their capital would have declined by as much as the bond price. And people who wanted to take out a mortgage after the market move would find themselves paying at least 0.41% a year (in market parlance, 41 basis points) more.
   11. Bond markets have power because they are the fundamental base for all markets. The cost of credit, the interest rate (on a benchmark bond), ultimately determines the value of stocks, homes, all asset classes.

How bonds affect government policy and politics

1. From a politician’s point of view, the bond market is powerful partly because it passes a daily judgement on the credibility of every government’s fiscal and monetary policies.
2. But its real power lies in it’s ability to punish a government with higher borrowing costs.
3. Even an upward move of half a percentage point can hurt a government that is running a deficit, adding higher debt service to its already high expenditures.
4. As in so many financial relationships, there is a feedback loop.
5. The higher interest payments make the deficit even larger.
6. The bond market raises its eyebrows even higher. The bonds sell off again. The interest rates go up again. And so on.
7. Sooner or later, the government faces three start alternatives.
   1. Does it default on a part of its debt, fulfilling the bond market’s worst fears?
   2. Or, to reassure the bond market, does it cut expenditures in some other area, upsetting voters or vested interests?
   3. Or, does it try to reduce the deficit by raising taxes?
8. The bond market began by facilitating government borrowing.
9. In a crisis, however, it can end up dictating government policy.

Retirement money in bond market

1. A large part of the money we put aside for our old age ends up being invested in the bond market.

War and the bond market

1. The ancient Greek philosopher Heraclitus declared, “War is the father of all things”. It was certainly the father of the bond market.

2. The Dutch verses below Pieter van der Heyden’s extraordinary engraving, The Battle about Money, say “It’s all for money and goods, this fighthing and quarelling”. But the inscription could equally well say: “This fighthing is possible only if you can raise the money to pay for it”.

3. The ability to finance war through a market for government debt was, like so much else in financial history, an invention of the Italian Renaissance.

4. If you buy a government bond while war is raging, you are obviously taking a risk, the risk that the state in question may not pay your interest.

5. On the other hand, remember that the interest is paid on the face value of the bond, so if you can buy a 5% bond at just 10% of its face value, you can earn a handsome yield of 50%.

6. In essence, you expect a return proportional to the risk you are prepared to take.

7. At the same time, it is the bond market that sets interest rates for the economy as a whole.

8. If the state has to pay 50%, then even reliable commercial borrowers are likely to pay some kind of war premium.

9. In such times, severe financial crisis occur as bonds crash in value and interest rates soar. The result is, business grinds to a halt.

Further reading

1. Bill Gross runs the world’s largest bond fund at the Pacific Investment Management Company (PIMCO)

TODO

1. Why Foreign Bonds Could Be a Game-Changer for Investors https://www.investopedia.com/foreign-bond-investment-benefits-11757026
2. Why China Buys U.S. Debt With Treasury Bonds? https://www.investopedia.com/articles/investing/040115/reasons-why-china-buys-us-treasury-bonds.asp
3. Three Major Questions Facing the ‘Beautiful’ Bond Market https://www.investopedia.com/three-major-questions-facing-the-beautiful-bond-market-11712580

Tags

1. Recipients of interest on bonds
2. Using U.S. Savings Bonds as a Long-term Investment