Bonds and the Bond Market

Podcast Transcript

One of the most important markets in the global economy is the bond market.

The bond market doesn’t get as much attention as the market for stocks. Yet, the global market for bonds is actually larger than the total value of all publicly traded stocks.

Moreover, bond markets have the power to influence policy and possibly even topple governments.

Learn more about bonds and the bond market, and how they work on this episode of Everything Everywhere Daily.

One of my favorite quotes comes from the political strategist James Carville. His nickname is the Ragin’ Cajun, and he was the campaign manager for Bill Clinton in 1992.

In the early 90s, near the start of the Clinton administration, he was stunned at the power of the bond markets to influence policy.

In an article in the Wall Street Journal, he said:

I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.

So, what exactly did he mean when he said the bond markets can intimidate everyone?

Before we get to that, let’s start at the beginning and address what exactly bonds are.

Let’s say you are a company or a government and need to raise money for a project. If you are a company, one option would be to sell shares of your company, which represent a stake in the company’s ownership.

Anyone who buys a share of stock usually hopes that the company will do well in the future and that the value of that share will increase.

Selling shares isn’t an option for governments, however. If they want to raise money, they have to take the other path, which is open to corporations: issuing debt.

Small businesses and consumers usually take out a loan from a bank. They go to a bank, talk to a loan officer, and make their case. The bank may then give them a loan, which they then have to pay back with interest.

That is one way to get money through debt.

Another option, usually only available to large institutions such as publicly traded companies and governments, is to issue bonds.

A bond is a loan made by an investor to the entity that issued the bond.

The borrower, called the issuer, promises to pay back the principal, the original amount borrowed, on a specific future date, called the maturity date. Along the way, the borrower usually agrees to make regular interest payments, called coupons.

Bond payments are called coupons because, back in the day, bonds were simply pieces of paper with coupons attached. You would remove the coupons and turn them in for your interest payment.

These old-style bonds were known as bearer bonds. The bond was owned by whoever held the physical piece of paper. These are rarely issued anymore because they turned out to be an excellent way to launder money. They are still used as plot devices in some movies.

With bearer bonds, there isn’t just a risk in the issuing institution not paying, but also losing the physical bond itself.

Here is an example of how a bond issue might work:

Imagine a government needs to raise money for some infrastructure project. Instead of raising taxes or cutting spending, it issues a 10-year bond with a face value of $1,000 and a 5% annual coupon rate.

You, the investor, buy the bond for $1,000.
Each year, you receive $50 in interest payments. $50 is 5% of $1,000.
After 10 years, you get back your original $1,000 investment.

So over the life of the bond, you’ve earned $500 in interest and got your principal back.

Instead of working with a bank as you would with a loan, the issuing institution would sell these bonds on the open market. They could be purchased by anyone.

So far, this isn’t too different than a standard loan, other than who is doing the lending.

What makes bonds different from loans is that they can be bought and sold on secondary markets just like stocks.

This is the bond market.

If you don’t know much about bond markets or bond trading, your first instinct might be to question why they exist at all. Stocks can keep going up in value without any real limit.

A bond, on the otherhand, has its terms baked in. In the example I gave above, the amount you will get in interest can’t change and the amount you get at the end of the term can’t change.

So, what is the point in selling it and why are they sold so frequently?

For starters, the initial auction for a bond only happens once. If you are unable to buy it in the initial auction, you would have to buy it from someone else in the secondary market.

More importantly, the value of a bond is highly dependent on interest rates.

In the above example, the bond had an interest rate of 5%. Lets say that interest rates go up and now people can buy bonds that have an interest rate of 6%.

Who would want a bond that pays 5% when you could have one that pays 6%?

The answer is that, all things being equal, you’d rather have a bond that pays 6% than one that pays 5%.

However, you can compensate for a change in interest rates by changing the amount you sell the bond for.

Yield refers to the return an investor gets from a bond. The most common type is the yield to maturity, which represents the total expected return if the bond is held until it matures, accounting for all coupon payments and any difference between purchase price and face value.

In my example, the yield to maturity of a ten-year $1000 bond at 5% interest would be $1,500 at its purchase.

That 5% bond can have the same yield as a 6% bond if you buy the 5% bond at less than the initial $1,000 that it costs. It might sell for only $950 to match the new higher yield. (I am assuming no coupons have been issued yet in this scenario.)

By the same token, if interest rates fall, that 5% bond is now more valuable.

Yields are one of the most confusing things about bonds and the bond markets.

Bond yields are inversely related to bond prices.

If demand for a bond increases, its price goes up, and its yield goes down.

If demand falls, its price drops, and its yield rises.

There are a host of things that affect bond yields.

If the central bank is expected to raise rates, yields tend to rise in anticipation.

Higher expected inflation reduces the real value of future payments, so investors demand higher yields.

If an issuer seems less likely to repay, yields rise to compensate for the added risk.

More issuance, an increase in the supply of bonds, or reduced investor appetite, a reduction in demand, can also push yields higher.

Not all bonds and bond issuers are created equal.

Some bonds issued by local governments, municipal bonds, have tax free interest, which means that they can have lower interest rates.

Some corporate bonds are convertible, which means that they can be converted to stock at the option of the bond holder.

The perceived level of risk of the bond will be reflected in the interest rate that the issuer has to pay.

Let’s say a large company, such as Apple Computers, flush with cash, issued a bond. They have a lot of money and revenue and are generally considered to be a low risk. They would be able to sell a bond at near-market rates.

However, a smaller company that isn’t as sure of a bet has to offer higher interest rates to compensate for the increased risk. These are often known as junk bonds.

Junk bonds are high-yield bonds issued by companies with lower credit ratings. Rating agencies typically rate junk bonds below investment grade.

Michael Milken, working at Drexel Burnham Lambert in the 1970s and 1980s, famously revolutionized the use of junk bonds. He saw an overlooked opportunity: companies with low credit ratings weren’t necessarily doomed to fail—they were often misunderstood or undervalued.

Milken developed a massive market for these high-yield securities, using them to raise billions of dollars for corporate takeovers and mergers, especially leveraged buyouts.

This brings up the subject of how bonds are rated.

Bond rating agencies, such as Moody’s, Standard & Poor’s (S&P), and Fitch, evaluate bond issuers’ creditworthiness and assign ratings that reflect the likelihood that the issuer will repay its debts.

These agencies analyze a wide range of factors, including the issuer’s financial statements, cash flow, debt levels, business environment, and economic conditions. The resulting ratings range from high-grade, indicating low risk of default, to speculative or junk status, indicating higher risk.

Bond ratings are usually assigned as: Aaa ? Aa ? A ? Baa ? Ba ? B ? Caa ? Ca ? C. Some agencies also have a D rating.

Investors use these ratings to assess risk and determine appropriate interest rates for lending. While rating agencies play a crucial role in financial markets, they have also faced criticism, especially during the 2008 financial crisis, for giving high ratings to risky securities and for potential conflicts of interest, since issuers often pay for their own ratings.

I want to end the episode by discussing the 800-pound gorilla in the bond world: United States government treasury bonds.

The US Government is the single largest issuer of bonds in the world.

As of the recording of this episode, there is a bit under $37 trillion dollars in bonds issued by the United States Treasury Department that are outstanding.

Of that, the federal government currently pays over $1 trillion annually in interest payments, which is now the third largest part of the federal budget, behind only Medicare/Medicaid and Social Security.

Treasury bills, Treasury notes, and Treasury bonds are all debt securities issued by the U.S. Department of the Treasury. They are fundamentally the same thing and only differ in their maturity lengths and how they pay interest.

Treasury bills, or T-bills, are short-term securities that mature in one year or less. They do not pay periodic interest. Instead, they are sold at a discount to their face value, and the investor receives the full face value at maturity.

Treasury notes, or T-notes, have intermediate-term maturities, ranging from two to ten years. They pay a fixed rate of interest every six months until maturity.

Treasury bonds, often simply called T-bonds, are long-term instruments with maturities greater than ten years, typically up to thirty years. Like T-notes, they pay semiannual interest and return the face value at maturity. Due to their long duration, T-bonds are the most sensitive to interest rate changes and inflation expectations.

A savings bond is the same thing, except that it is sold in smaller amounts, so they are more affordable to individual investors.

Under normal conditions, long-term bonds yield more than short-term ones because investors demand higher returns for locking up their money longer, compensating for inflation and uncertainty.

An inverted yield curve is a financial phenomenon in the bond market where short-term interest rates are higher than long-term interest rates.

This inversion typically reflects investor expectations that the economy is heading for a slowdown or recession.

Old bonds are constantly coming due, and new bonds are always being released. The new bonds are often sold to cover the cost of redeeming the old bonds.

Going back to the original premise of the episode, bond markets are so powerful because they can increase or decrease bond yields, which forces the government to offer a higher or lower interest rate to stay competitive.

What happens if the Treasury Department has an auction for bonds and no one wants to buy them?

In the case of the United States Federal Government, they would be purchased by the Federal Reserve Bank.

One reason Treasury Bonds are considered such a safe investment is that the United States would literally never have to default on its debt.

All debt is denominated in dollars, and the government can produce as many dollars as it wants. This is effectively what happens when the Federal Reserve buys bonds that can’t be sold at auction.

However, that isn’t necessarily a good thing, as instead of defaulting on the debt, they are debasing the money supply.

I’ll probably be doing a full episode on the federal debt in the future.

Bonds and the bond market are an extremely important part of the global economy.

One big reason is that the markets can quickly change bond yields, which exert powerful influence over governments and public policy.

The Executive Producer of Everything Everywhere Daily is Charles Daniel. The Associate Producers are Austin Oetken and Cameron Kieffer.

Today’s review comes from listener D DuDe over on Apple Podcasts in the United States. They write.

Great podcast! I love history. I highly recommend this podcast. I also love that it’s short. Please add more episodes on espionage and gorilla warfare.

Thanks, Dude! The good news is that I definitely have some episodes that touch on the subjects of both guerrilla warfare and espionage. I don’t have any time frame on them, but they are on the list.

Remember, if you leave a review or send me a boostagram, you, too, can have it read on the show.