Many people do not understand bonds. This isn’t a disaster for society, but some households’ finances can suffer if they invest in something they do not fully understand.
Furthermore, misunderstandings about the role that bonds and bond markets play in modern economies can undermine public support for prudent national economic policies.
A bond is just an IOU, a legal document that records a loan from one party to another and how the principal and interest on that loan will be repaid. Thus, it is like the “promissory note” that one signs for a student or car loan.
In contrast to such consumer loan documents, bonds are standardized documents. Some entity, either a private corporation or a unit of government that issues or “sells” bonds, is offering to borrow money from the public. The terms under which the entity is willing to borrow money — amounts, interest rate and repayment schedule — are specified in the bonds.
The institution selling the bond may borrow tens or hundreds of millions of dollars with one bond issue, but each bond in an issue carries the same terms.
Most bonds come in multiples of $5,000 or $10,000 and are for terms of 10 to 30 years. Some government bonds are for shorter periods, perhaps as few as 13 weeks. These shorter-term bonds are called “bills” and “notes,” a distinction unimportant to the average consumer.
In the sense that a bond issue is an offer to borrow money, bonds are like certificates of deposit offered by banks and credit unions. CDs are a bank’s offer to borrow money under a set of terms they specify. The saver/lender can choose to accept such terms and buy a bond or CD or reject them and look for alternative investments.
SAFE INVESTMENT
When issued by a unit of government in the United States or by a major corporation, bonds are considered a very safe investment. The investor can be quite sure of getting principal payments as specified in the bond and getting the principal amount back when the bond comes due or “matures.”
No one who lent money to the United States government by buying a U.S. Treasury bond has ever failed to get the promised principal or interest. Some corporations and local government units have defaulted, but such failures to repay are quite rare.
Many people then wonder if the principal and interest promised by bonds is almost always paid, how can the value of bonds fall 10 percent in a few weeks as they have since June 13 of this year?
The answer lies in the fact that the initial buyers of bonds, the persons who in effect lend money to the government or a corporation, need not hold that bond until the stated maturity date. They can sell their bonds at any time to any willing buyer. But they may get less than the bonds’ face value if they do.
In the 1980s, U.S. homeowners became familiar with having their mortgages sold by the mortgage company that made the initial loan to some other lender. Many people were initially frightened when they received a letter saying their mortgage had been sold and instructing them to remit payments to another address. They soon found out, however, that this did not harm them in any significant way.
Just as most homeowners are not affected by who owns their mortgage, corporations and governments do not care who holds their bonds. It is common for a particular bond to have several different owners between its initial issue and its maturity.
MODERN MATURITY
The face value of the bond will always be paid to a bondholder at maturity, but this does not necessarily mean that the bond will be worth its face value if sold to someone else before maturity. It all depends on how the interest rate specified on the bond compares to rates of return on alternative investments of similar size, risk and term at the time a bond is sold.
If you own $10,000 worth of bonds paying 8 percent a year and the going interest rate for newly issued bonds is only 5 percent, your bond will be very attractive to potential buyers. An $800 annual interest payment is better than $500. Because your 8 percent bond is so attractive, you will be able to sell it for more than its face value of $10,000.
How much more depends on the interest rate differential noted and on how many years remain before your bond matures. Even if a buyer pays $11,000 or more for a high-interest bond, the buyer will only get the original $10,000 back from the issuer when it matures. The shorter the time before a bond matures, the less of a premium it will command for a given interest rate differential when sold in open bond markets.
If you decide to sell a bond with a specified interest rate that is lower than prevailing rates, you will have to accept less than face value for it. If your bond yields 4 percent and new bonds yield 9 percent, yours will not be very attractive. You will succeed in getting rid of it only if you put it on sale for a lower price.
There is thus an inverse relationship between the price of bonds and interest rates. Whenever interest rates rise, the market value of all existing bonds goes down because they are now worth less in comparison to newly issued bonds. Whenever interest rates fall, the market value of all existing bonds rises.
The fact that many bonds are bought, sold and resold in such “secondary” bond markets explains why the value can fall 10 percent in six weeks even if the full principal and interest promised by the bond eventually will be paid.
The decline in value is a drop in the market price of bonds that have not yet matured. If you have a bond and sell it now, you will get less than if you had sold it in late May. But if you hold it until maturity you will get all the principal and interest promised.
© 2003 Edward Lotterman
Chanarambie Consulting, Inc.