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Mark's Market Blog

Part IV: Bonds

By Mark Lawrence

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A bond is a way for someone to borrow money. When you issue a bond, you promise to pay some particular amount of money to the bond holder on some particular date. The bond may also optionally include several payments to be made at dates before the bond is due. In this case, the bond will have "coupons" attached to it which may be redeemed on these dates for these payments. You can buy bonds with or without the coupons. Sometimes people will buy a bond with coupons, strip off the coupons, and sell the bonds and the coupons separately. Obviously the bond is worth less after the coupons are taken off.

Suppose you buy a bond which says in 91 days you will be paid $10,000. These bonds are available from the US Federal Government, and are called 91 day Treasury Bills, or 91 day T-Bills. You buy this bond at a discount from the face value. Currently (7/7/05) a 91 day $10,000 T-bill sells for $9920.50. The $79.50 discount corresponds to your interest, in this case an interest rate of about 3.2% per year. This means if you were to put $9920.50 in the bank at 3.2% interest for 91 days, at the end of the 91 days your account would have $10,000.00 in it. Very simplistically, there are about four 91 day periods in a year, and four times $80 is $320, which is 3.2% interest on $10,000. The lower the price you pay for the bond, the more interest you are earning. This is a point which many people find confusing: the higher the interest rate, the less the bond is worth. If you buy a 10 year T-bill and interest rates go up, then the value of your bond goes down. If you hold the bond for the entire 10 years, you will be paid the agreed upon amount. But if you decide to sell the bond to someone else before the bond is due, then they will expect to buy the bond at a discount that reflects current interest rates. If the interest rate has gone up since you bought the bond, then the corresponding discount also goes up and the bond price goes down.

About once a week the U.S.Treasury has auctions where they sell T-Bills. The auction price determines the effective interest rate. The U.S.Treasury can therefore lower interest rates by selling fewer bonds - if there are fewer bonds, people will pay more for them, and the interest rate is lower. They can raise interest rates by selling more bonds. If there are lots of bonds available, people will pay less for them, and the effective interest rate is higher. Since there is no practical limit to the number of bonds the Treasury department can print up, they can make interest rates be pretty much anything they want. In practice, this particular power of the government is never used: each week they sell only enough bonds to raise the money to pay off the bonds that have come due, and a few more bonds to raise the money to finance this week's budget deficit.

Importantly, this means if you own bonds you are very interested in the economy. When we're headed into a recession, the Federal Reserve Board will take actions to lower interest rates, making more money available to help bring us out of the recession. Lowered interest rates mean that your bonds will go up in value. If the economy is doing well, perhaps too well, the Fed may decide to raise interest rates so that there is less money available and the economy will "cool off." This raising of interest rates means your bonds will lose value. The Fed is a separate agency from the Treasury. They make their changes in interest rates by attending the Treasury auctions and buying more or fewer bonds. Since the Fed cannot buy more bonds than the Treasury is selling, in the end the Treasury actually has more power than the Fed, and the Fed lives at the Treasury's whim. In practice, the Secretary of the Treasury reports directly to the President, and the Fed is an independent agency, so it suits the President to let the Fed do what they will and take the heat. Reagan could have instructed his treasury secretary to lower bond prices and raise interest rates to stop inflation, but it suited him better to let Paul Volker and the Federal Reserve Board take this action. It all worked, so now both Reagan and Volker are heroes. Had it failed, it would have been Volker who found himself short a parachute, not Reagan. The Chairman of the Fed is very aware that his power depends on the whim of the President, so it is common for bond prices to go up and interest rates to go down a few months before the Presidential election, thereby heating up the economy and making the current President look better. It's equally common for bond prices to go down and interest rates to go up just after an election, to repair the damage done before the election.

Because of the Fed, bonds go up when the economy is bad, just when stocks go down. Bonds go down when the economy is good, just when stocks go up. So there's a very nice trade off between owning stocks and owning bonds, depending on where the economy is headed. There's one huge difference: stocks move a small amount every day. Bonds, on the other hand, make a big sudden price jump every time the Fed announces they are going to raise or lower interest rates. This has lead to an entire industry watching Alan Greenspan to see how he folds his handkerchief and how many sugars he took in his coffee this morning. Alan, meanwhile, seems to delight in making cryptic and indecipherable public statements.

Bonds are issued by a lot of entities. The U.S.Treasury, the various state governments, various companies, and foreign governments and companies all issue bonds to raise money. Bonds are rated according to their "quality," meaning the likelihood that you will be paid back as opposed to someone declaring bankruptcy and you never getting your money back. Standard and Poor's is a company that rates bonds, from AAA (the best) to CC and C aka "junk" (the worst), and finally D for "default," meaning the bond is already due and not being paid. Companies work very hard to maintain a high S&P credit rating, as the lower their rating, the less their bonds will be worth, and the higher the interest they will have to pay to raise money. The various automotive companies sell a lot of bonds to raise money to finance cars and leases. State governments sell a lot of bonds to raise money to build schools and highways.

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