Demystifying Bonds

My initial plan was to explain the ongoing bond-buying program taken by the FED and why the end of it (which is inevitable) frightens investors and emerging economies so much. Though, I realized that I should write that post next, since it wouldn’t make sense to explain the prior without first explaining the bond market. This post, which contains extracts from The Ascent of Money: A Financial History of the World by Niall Ferguson, will explain what bonds are and why the bond market is the single most important market of a country.

What are bonds?

Selling bonds is a way of borrowing money. Large corporations, governments and municipalities can issue bonds. Corporations might need to borrow money to invest on a new technology, expand to a new market or many other reasons. Sometimes, bank loans are not enough, and the company also does not want give away their equity by selling stocks, so their other option is to sell bonds. We must make the primary difference between stocks (equity) and bonds (debt) clear. By buying a stock of a company, you become an owner, and you will receive part of the future profits and sometimes even voting rights. By buying bonds, you are simply a creditor. A bond is a contract. The company or government will borrow money from you, pay an interest rate annually (also called a coupon), and after a few years when maturity date is reached, it will also pay the face value (initial amount). Bonds can be traded in the bond market and normally have a fixed interest rate. A few bonds, however, are floating-rate bonds, meaning their interest rates adjust depending on market conditions. Since bonds are traded, if you buy a bond it doesn’t mean that you are stuck with it for the next 10 years; you can simply sell it. Their price fluctuates. If you sell your bond for a lower price than what you paid, you are selling at a discount. If you sell it at a higher price than you paid, you are selling at premium.

The importance of the bond market

Bill Gross, the manager of the world’s largest bond fund at the Pacific Investment Management Company (PIMCO), said “Bond markets have power because they’re 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 assets.”

Niall Ferguson, one of Britain’s most renowned historians, explains how the bond market affects an entire nation. The Ascent of Money, page 65-68:

“Government (and large corporations) issue bonds as a way of borrowing money from a broader range of people and institutions than just banks. Take the example of a Japanese government ten-year bond with a face value of 100,000 yen and a fixed interest rate or “coupon” of 1.5 percent… The bond embodies a promise by the Japanese government to pay 1.5 percent of every 100,000 yen every year for the next ten years to whoever owns the bond. The initial purchaser of the bond has the right to sell it whenever he likes at whatever the market sets. At the time of writing, that price is around 102,33 yen. Why? Because the mighty bond market says so.

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. First, a large part of money we put aside for our old age ends up being invested in the bond market. Secondly, because of its huge size, and because big governments are regarded as the most reliable borrowers, it is the bond market that sets long-term interest rates for the economy as a whole. When bond prices fall, interest rates soar, with painful consequences for all borrowers. The way that works is this. Someone has 100,000 yen they wish to save. Buying a 100,000 yen bond keeps the capital sum safe while also providing regular payments to the saver. To be precise, the bond pays a fixed rate or “coupon” of 1.5 percent: 1,500 a year in the case of a 100,000 yen bond. But the market interest rate or current yield is calculated by dividing the coupon by the market price, which is currently 102,333 yen: 1,500 ÷ 102,333 = 1.47%. Now imagine a scenario in which the bond market took fright at the huge size of Japanese government’s debt.  Suppose 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 interest is paid. In such circumstances, the price of the bond would drop as nervous investors sold off their holdings. Buyers would only be found at a price low enough them for the increased risk of a Japanese default or currency depreciation. Let us imagine price of our bond fell to 80,000. Then the yield would be 1,500 ÷ 80,000 = 1.88 percent. At a stroke, long-term interest rates for the Japanese economy as a whole would have jumped by just over two fifths of one per cent, from 1.47 to 1.88. 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.”

Conclusion

Ferguson explains the importance of the bond market to a nation. If the bond market loses value, all other markets will also lose value, interest rates will soar, and by consequence, every citizen will suffer. It's no coincidence that Alan Greenspan, former Federal Reserve Chairman, once said “If bond prices continued to rally, it would be by far the most potent [economic] stimulus that I can imagine.” When nations are considered credit worthy, just like individuals, they can borrow cheaper money, meaning that they pay a smaller interest rate. If a country becomes unworthy of credit, or riskier, money becomes more expensive. Since the bond market defines the long-term interest rate for all other markets, money becomes more expensive for everyone in that country, killing economic growth. Lastly, throughout history the bond market also proved to be a decisive instrument for countries that were at war. When most of the working population is in the battlefield, its very costly to supply your troops, pay for weapons, airplanes, ships and etc.. Ferguson traced the use bonds to as far back as 14th century in Italy. Then, Florence, Pisa and Siena were at war with each other, and they made use of bonds to finance their expenses.

I hope that you enjoyed this post and that you now superbly understand the importance of the bond market. My next post will explain the bond-buying program taken by the FED, and why the end of it (which is inevitable) frightens investors and emerging economies so much.

Thank you for reading,

Pedro

Sources

Ferguson, Niall. The Ascent of Money: A Financial History of the World. The Penguin Press, 2008. Print.