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.
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.”
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 borrower who issues the bond, could sell the debt of £100 to somebody who might be desperate to give me £105 in my hand. Or – in unusual circumstances the borrower could sell the debt for less than £100.
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 (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 owes to the lender . 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 borrower (who issues the bond) can sell it (which is a debt) for less or more money.
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 iff 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.
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