Bonds – what they are and their importance
There is much confusion out there about what bonds are. I’ve seen so-called experts get it wrong, and then mislead people. The recent importance of the ‘bond market’ has come about as there is talk about an ‘inverted yield curve’. Not much will be said about that. In this post I focus on the basics. The concepts here may require careful time studying what’s going on.
This post has been revised on 2019-12-01 due to previous typographical errors and need to clarify more carefully the distinction between bondholders and bond issuers.
What is a bond?
Quite simply a bond is a loan. Somebody lends somebody money. It’s that basic. When you purchase a bond, you lend money to the entity you purchase from. If that sounds crazy and you don’t believe me see it here at Investopedia: “A bond could be thought of as an I.O.U. between the lender and borrower that includes the details of the loan and its payments.” Further “Bonds, or fixed income investments, are essentially loans from an investor to a company or government. Bond investors receive periodic payments based on the interest rate at which the bond was sold.“
Right there is the first confusing thing about bonds i.e. it is a loan so how come it can be sold? And – lending money to someone is not considered a purchase in ordinary life.Treasuries are usually ‘book-entry bonds’ sold by the US Department of the Treasury. Book-entry basically means there is a record of ownership, enabling the bond to be sold basically like a share. Thinking of a bond as a share makes it simpler. A share is record of purchase of an equity, which can be sold. In a sense the share is owed it’s face value, subject to market forces. The difference is that shares are not seen as loans or debt owed. But similarly bonds are subject to market forces (demand etc).
Breaking it down – if I lend you £100 that’s a bond. As I am the lender, it means I am out of pocket. You owe me £100, which as a condition of the loan there could be a mutual agreement to pay interest at say 2% or 10% – whatever rate we agree. So why do they call it a purchase? The bond is represented by an instrument or certificate or record of the sale – and that can be sold on to anybody willing to pay. So in the above example the bondholder, could sell the debt owed to me of £100 to somebody who might be desperate to pay £105. Or – in unusual circumstances the bondholder (the lender) could sell the debt for less than £100. The market price is subject to demands in the bond market.
So in effect the bond purchase (which is debt) can be sold like anything else. If you find that sounds mad that the borrower is the issuer, read Investopedia where they say, “The borrower (issuer) issues a bond that includes the terms of the loan, interest payments that will be made, and the time at which the loaned funds (bond principal) must be paid back at maturity date.” – don’t argue with me!
The core concept of a bond is usually about some entity (the lender) purchasing from a bank or other organisation (the borrower). This ‘purchase’ is a debt that the borrower (issuer) owes to the lender (who becomes the bondholder). Now that’s strange because we’re talking about purchases – and in everyday life we purchase things that we can eventually hold or feel (or see) the effects of in our hands e.g. cars, apples, pens etc. When in ordinary life people take out a loan, the money in hand is seen as a credit – but actually it is a debt!
But in this sort of purchase concerning bonds, the lender is purchasing a ‘negative’ i.e. a debt with interest owed. And even more crazy is that the purchaser (being the lender) is handing over money to the borrower in exchange for some document that says to the borrower what is owed. What would the purchaser (lender) do with this bond? The lender doesn’t have to do anything except collect interest and later on the principal from the borrower, when the maturity date is due. But the lender can sell it (which is a debt) for less or more money.
- These are borrowers. So if the US Govt issues a bond, they’re borrowing from people or corporations.
- They issue the bond to lender(s), who can then sell the bond.
- Whilst bond issuers have money in hand, they owe bondholders.
- Bond issuers are indebted to their lenders (who are the bondholders).
- A bondholder is an investor or owner of debt securities that are typically issued by corporations and governments.
- Bondholders are essentially lending money to the bond issuers. They are the lenders.
- Bondholders receive their principal back when the bonds mature and periodic interest payments for most bonds.
- Bondholders may profit if the security they hold increases in value.
- Bondholders don’t have ‘reserves’ or money spend as a result of the bond. (This is the nonsense that some experts throw around).
So if China holds US Treasuries, then China is holding American debt. What does that mean? It means America owes China money. China has loaned money to America. It doesn’t mean that China has money to spend because of holding US Treasuries. You can’t spend what you are owed!
Bonds as securities: Whilst one cannot spend what one is owed, the debt (in a bond) is backed by the bond issuer. In the case of government bonds, they are seen as the best borrowers. So it is possible to use the bond (the debt) as a security). In other words the bondholder will say, “Hey, I’m backed by the government of the USA for $1 Billion”. If ‘you’ (at third party) lends me $200 million, I’ll use the backing of the government debt – I can pay you back on bond maturity. I’m happy to pay you X%”. In this way the debt is used as a security to release money from a third party.
What is yield curve inversion?
To see what yield means click here. Normally if somebody is lending money for longer periods of time, they’d expect to get a bigger yield. That’s fair enough. When there is yield inversion, it means that people lending money for the shorter term are getting more than those who lend for the longer term. That may not seem fair, but that this is what happens sometimes with bonds. There are all sorts of reasons why this might happen. The important point though is that inverted yields are a bad thing. Most of the time if the situation persists for more than three consecutive months in a year, it heralds a recession. To learn more go here.
How are bonds confused?
- So-called experts have referred to the holder of the bond (the lender, the purchaser) having money to spend. The holder cannot have money to spend because they just lent the money! 🙄
- Other experts have referred to bond as ‘reserves’ which can be used to buy stuff or fund projects. This is pure nonsense. The only way to ‘spend’ on the debt is to sell it to someone else who is willing to pay to take over the debt. It is possible to undersell the debt to another entity. For example I could sell my debt of £100 loan above to a third party, if I’m happy to received say £80. In that scenario I may believe that the entity I originally lent money to may have trouble paying me back, so I’d be happy to cut my losses in selling to a third party for a reduced return. In other words let the new third party suffer if they wish to take the risk.
For an exposure to Bonds click on the mindmap link below (goes to a new page). Icons in the mindmap, can then be clicked on or hovered over for more information.