The Puzzling World of Bonds

Written By: The WealthCycles Staff

While stocks remain the financial world's perpetual media darling, bonds, the frumpy standby of the risk-averse, are in fact a larger market and play a far larger role in the mechanics of the global financial system.

While the total value of stocks across the globe is just above $50 trillion, bonds tip the scales at over $80 trillion worldwide.                     

Bonds are the center of an intricate web that involves derivatives, stocks, and even commodities.

Many investors are spooked by the mysterious world of bonds and its inner workings: yields, rates, convexity, and the see-saw between a bond’s price and yield, all contribute to the confusing complexity that surrounds the jargon-filled realm of the bond market. But its outsized impact on the global economy makes it essential that all of us gain at least a basic understanding of how bonds work, because the ebbs and flows of the bond cycle have a very real impact on our personal financial well-being.

Simply put, bonds are debt.

Bonds basically say: "I owe you (IOU) X-amount of currency, plus X-amount of interest."

—Michael Maloney, Guide to Investing In Gold & Silver

But, there is more to it than that. Bonds set the cost of borrowing, determine international currency flows, and play a huge role in determining the value of each nation’s currency. That means bonds have a direct effect on the dollars, euros, pesos or yuan in your wallet or bank account.

When an individual needs to borrow cash, he or she has a few options: ask a bank for a loan, use lines of credit, or simply borrow from a friend. But big businesses, municipalities or counties, and national governments have much bigger borrowing needs than a single bank, line of credit, or friend could or would be willing to lend.

So instead of taking out a loan, large corporations and governments borrow currency by issuing bonds. Each bond is essentially an IOU that stipulates a principal loan amount, the amount that the bond issuer must periodically pay in interest, and the period of time for which the loan will be outstanding.

Investors then come to the table and buy the bonds for a price that they think is right. The cash paid by the purchasers is handed over to the bond issuer, who can use the proceeds to fund its spending for business expansion, infrastructure construction or other purposes. Oftentimes, governments must borrow just to fund their day-to-day operations.   

The investors who bought the bonds can hold onto them, collecting their interest and principal payments, or they can trade the bonds in what is called a secondary market.

The ability of bonds to trade on a secondary market is important. Let’s say you as an individual borrowed cash from a friend, and you promised to pay her in a year. Six months down the road, however, your friend runs into financial trouble, and she asks you to pay back the cash she lent you. It would be troublesome if you had sunk the cash you borrowed from her into something and couldn’t get it back immediately.

Bonds, on the other hand, can be bought and sold even after the original loan has been made. If a bond investor needs cash, he can usually sell his bonds without taking a huge loss. When an investor sells his or her bonds, he transfers that asset to another person who essentially becomes the new lender. Since anyone can be a bond investor, bonds distribute the lending and risk amongst many investors instead of just a single bank or lender.

Bonds Effect on the Cost of Borrowing

Interest rates play a huge role in the global economy because they determine the cost of borrowing on credit cards, car loans, student loans, mortgages and small business loans. Interest rates determine the cost of borrowing for national governments, corporations, states, and municipalities, and they have a huge effect on economic activity.

Government bonds (like U.S. Treasuries) are considered low-risk because they are usually backed by the “full faith and credit” of the government—essentially, they are backed by the government’s ability to extract taxes from its people.

For that reason, the interest rates the government pays on its bonds are relatively low. Likewise, a stable corporation with a sound credit rating will pay a lower interest rate than a company with a shaky credit rating.

Yield is the rate of a bond investor’s return—based on what percent return they can earn on each dollar they invest. If you lend to someone, you will demand a higher yield from a risky borrower than from a very creditworthy one. These yields are the interest rates that help determine so many critical factors in the global economy.  

As such, a Treasury bond will pay a lower yield than a bond issued by a storied company like Johnson & Johnson (investment grade). But J&J will pay less in interest than a bond issued by, say, Shady Joe’s Mail-Order Bride Inc.   

—Wall Street Journal’s “What Is A Bond”

The same principles that apply to businesses apply to countries as well. A nation with huge debts and deficits will have to pay higher interest rates than a nation with its finances in order. But even the presumed safety of government bonds is beginning to unravel.

As we wrote recently in the WealthCycles.com article, Are Government Bonds Just More Worthless Paper?

Once upon a time, government bonds—backed by the full faith and credit of governments with the ability to tax their populace—were considered the safest, healthiest investment possible. But botched responses to financial crises around the globe have put virtually every government in the world in a position so fragile that the default of one can spread like the plague, as investors begin to see government bonds for what they truly are—worthless paper.  

Our global monetary system is built on central banks creating currency and using it to purchase bonds from the country’s finance ministry.

Now the foundation for this system is a bond issued by a country's Treasury, Ministry of Finance, or whatever they call it in their country ... for now we're going to call it the government. These government bonds are the foundation bonds of the world's monetary system.

Many entities buy these government bonds. But when a country wants to create some currency the government sells a bond to its central bank. The central bank writes a check against a zero balance in its checking account for however many dollars, euros, yen, or whatever the government wants, and it buys the bond. The currency has now sprung into existence, and later can be used to redeem the bond. Therefore, the bond is an IOU for the currency. But since the currency is also a claim check to redeem the bond when it matures, the currency is an IOU for the bond. Get it? No, me neither. That's because it's crazy. If you or I did this, we'd be accused of fraud.

—Michael Maloney, Guide to Investing In Gold & Silver

Once the government has obtained the cash it needs by selling bonds, it spends that cash by paying government employees, going to war, or building roads, bridges, and lighthouses. When a person needs to buy a home, she goes to her bank and takes out a loan by signing a mortgage. The interest rates borrowers pay on a mortgage is based partly on a borrower’s creditworthiness, or how likely she is to repay the loan on time without defaulting. A risky borrower with a poor credit score might pay a higher interest rate than a borrower with a pristine credit record.

But the interest rate that borrower pays on her home mortgage is largely dependent on government bonds’ interest rates, which are often used as a reference point by banks and other lending institutions. When governments have to pay higher interest costs, so does everyone else—banks, businesses, individuals. Governments that have amassed spectacular amounts of debt are like individuals with worsening credit scores—in order to get a loan, they will be forced to pay a high interest rate.   

Government bonds, like currency, are based on a government’s solvency—or at least its appearance of solvency. A government can try to sweep its messes under the rug, by borrowing and kicking the repayment can down the road to future taxpayers. But odds are no government will  be able to maintain the charade forever. Its citizens will eventually figure out that in fact there is nothing much backing those bonds, and that the “full faith and credit” of governments that continually pass today’s deficit spending to tomorrow’s taxpayers is nothing more than an enormous Ponzi scheme. Once the populace catches on to the ruse of government bonds and paper currencies, governments’ ability to indebt the future to support present spending will come to a screeching halt. The resulting impact on the global economy will be catastrophic.

That’s why even those who don’t invest in the bond market still keep an eagle eye on bonds and the fiscal solvency of the governments who are peddling them—they indicate the turning of cycles. While the puzzle of bonds can be complex, solving it, or even understanding the process, will help you with navigating your way to a secure financial future.

How are coupon rates determined? I believe I read somewhere that they keep it close to interest rates when issuing new bonds

Is this why US government needs low interest rates, so when selling new bonds they can afford the new coupon rate? Or am I getting all confused?

This is correct, they are contractual, and are indeed subjectively linked to yields expressed in markets.

Hi ,

I recently read that FED earns a profit as a result of the interest on the treasury bonds that it holds, and it pays back that interest back to the treasury.

Now i was not able to understand how is the profit.i.e., the interest on the bonds is paid by treasury to FED.

Also why does the FED return back its profit back to the treasury.

Regards,
Vineet

Hello vineetrk,

The following articles explains how the Fed earns a profit and why they return the profit they make.

http://wealthcycles.com/blog/2011/01/10/fed-profits-off-us-taxpayer

http://wealthcycles.com/blog/2011/11/21/does-the-federal-reserve-pay-taxes

Earl

Am I understanding this correctly? The longer the term of the t-bond that a government buys, the more of a signal that they are creeping closer to insolvency, due to printing currency that country's GDP can't sustain? Hence, the enormous fear the markets had a few weeks ago with the italian bond yields..

Love your information.

Thanks Vongleichent. We'll keep it coming.

nick - WealthCycles Administrator

Dear reader,
The conversion to a national, debt-free currency does not have to be catastrophic. Simply use the current money supply as the inventory of money iin the new system.Ordinary folks won't notice any difference.

The differences are of course:
- 100% reserve requirement which means banx can't vary the money supply.
- New currency is simply introduced into the government budget. Yes, if governments introduce more money than economic growth you will get inflation, a form of tax. But this currency is not debt so no interest is owed. Interest that cannot be paid out of the money supply without causing deflation, so it gets paid by bankruptcies. That is the intention of this system. Bankruptcy is not "cleaning the slate", it is someone else owning the assets you've worked for (you meaning governments, states, cities too).

Thank you

Great article - I have one question, though:

You write: "When governments have to pay higher interest costs, so does everyone else—banks, businesses, individuals."

I was wondering why this is the case. Why is it not possible that, while interest rates for government bonds might raise, interest rates for mortgages for example remain low.

In other words: Why exactly do all interest rates have to go up, when governments have to pay higher interest costs?

Since governments have the power to tax, they (most of the time) have been deemed the lowest risk borrower. If the interest rates, or borrowing costs, of the lowest risk borrower rise, all other borrowers would be pushed up as well. The idea is that since a mortgage is more risky than a government bond, all else equal, mortgages will always be at a higher interest rate than governments bonds.  

This is the case 99% of the time but there are certain circumstances where this is not true. There have been cases where a corporate borrower (Berkshire Hathaway comes to mind) actually have slightly lower borrowing costs than the government.

As government solvency comes into question for more and more investors, however, we will be seeing this type of thing more frequently.  

Got it - thanks!

Great article but few questions.

Are the Bond rates set by the Federal Reserve? Does it go up and down when money is printed or they just set a arbitrary rate? Why are rates going up even after Fed proceeding with QE2?

When Fed says its lowering interest rates does it mean they are setting the interest rate or they lower it by printing money?

Thanks.

Bonds rates are not necessarily set by the Fed, but the Fed does hugely effect the bond market. They are the largest holder of U.S. bonds, so they have an enormous effect. The Fed sets targets for short term U.S. Treasury rates, and then buys or sells Treasuries until they rates are around their target. They do this with "open market operations," in which they either create currency and purchase bonds, which lowers rates; or sell bonds (which they keep on their balance sheet) and take in currency, which raises interest rates.

These targets are based on things like economic activity, inflation, stock prices, consumer confidence, etc. The Fed used to exlclusively play with short term rates (i.e., less than 2 years), but in the recent Financial Crisis, the Fed has jumped into bonds of all maturities, including the longest maturity U.S. Treasury, the 30-year Treasury bond.  

The short answer is that rates are going up because investors are selling Treasuries. There are numerous reasons why this could happen, which we will write about in an upcoming article.

testiomials Bonds have never received the media attention stocks do, but they outweigh stocks in size, economic influence, and impact on your personal finances.”

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