What Are Bonds in Economics and How Do They Work?
You may have often heard about the governments or corporations issuing bonds (both short term and long term) to borrow money. Governments at all levels may be in dire need of funds in case of sudden political insurgencies like war or may need funds to construct roads, dams, etc. Similarly, corporations may need sudden funds to grow their business or undergo research and development or buy equipment or real estate. All these sudden expenses can be met through bond securities.
Here a question that often pops in one’s mind is, why don’t these organizations take short-term loans from banks or other financial institutions because credibility will never be an issue for getting bank loans for these large organizations; then why not go the safest way? The answer is that these large organizations or the government itself need much more funds than an average bank can provide, and therefore they issue bond securities to raise funds. Organizations can also issue stocks, but then it would require a proper stock exchange to carry on the transactions; with bond’s securities, no such exchange is mandatory. B o n d trading can be done anywhere the buyers and the sellers make a deal. But what are bonds in economics?
A Bond is an investment-grade security that represents the corporation’s debt or the government that issues it. When the government or a company issues a bond, it means they are borrowing money from the bondholders or the lenders, and then these organizations use these borrowed funds to execute financial obligations. Unlike stocks, a bond does not represent ownership in a company, but it represents a credit or loan from the buyer to the issuer of the bond securities. The price of a bond is inversely correlated with the interest rates, which means that when the interest payments rates go up, the bond’s price falls drastically and vice versa. A balanced investment portfolio includes both bond securities and stocks, as such bonds are less risky than stocks. Bonds help in hedging the risks of stocks which are more volatile investments than stocks. A bond can also provide steady income after your retirement years while preserving the existing capital. Owners or issuers of the bond securities are known as creditors or debtholders.
Various Types of Bonds
There are various types of bonds in the market, as discussed hereunder in detail.
1) U.S. Treasuries
Treasuries are considered as the safest bonds probably existing on earth. Treasuries are issued by the U.S. Federal government to finance its budget deficits. Treasuries are backed by Uncle Sam’s taxing authority, and therefore they are considered the most credit-risk free investment grade.However, the Treasury yields are always at the lowest, but they perform much better in times of economic downturn than higher-yielding bond securities. Treasuries are extremely liquid, and the payments often fail to keep pace with the inflation existing in the economy. Interest income from Treasury bond securities attracts federal income tax, but the income is exempt from state income taxes.
Treasuries are often used as benchmarks to price all other bonds that are issued by corporates or municipalities. Treasurys are available in $1,000 increments and are sold via auction. The bond price and the extent of the interest rates that will be paid out for the bond are determined in the auction. Investors can either visit the government website of Treasury bond securities, or they can go via a broker or banker. However, they can also be traded as any regular security on the open market.
Treasurys are also categorized into the following, having distinct characteristics.
a) Treasury bills
Treasury bills have maturities of 1 year or even less. Instead of making the interest payments to the bondholders, these bond securities are issued at a “discount,” which means you pay less than its face value when you buy the treasury bill, but get the total face value back at its maturity. This redemption of the total face value of the bond at maturity is what the bondholders earn as interest, though indirectly.
b) Treasury Notes
Treasury notes’ maturity period varies between 2 years, five years, and ten years issued in increments of $1000. Mortgage rates are priced off of the 10-year Treasury note, and so these notes are often termed as a ‘10-year bond’.
c) Treasury Bonds
These bonds are issued in terms of 30 years, and they pay interest after every 6 months till the maturity date.
d) TIPS or Treasury Inflation-Protected Securities
As the name suggests, TIPS have a return that fluctuates with inflation. TIPS are sold with 5,10, and 20-year terms.
TIPS are used to protect the investor’s portfolio against inflation. These securities usually pay a lower interest rate as compared to other Treasury bonds, but their payments (Principal plus interest) are made after every six months after adjusting with inflation measured by the Consumer Price Index.
As TIPS attaches federal taxes on the increase of the principal amount, it is better to hold these bonds in a tax-deferred account, like an IRA (individual retirement account). When these Treasury Inflation-Protected Securities mature, investors either receive the adjusted principal value or the original principal value, whichever is greater.
e) STRIPS or Separate Trading of Registered Interest and Principal of Securities
STRIPS are essentially Treasuries for which the coupon rate and the face value amounts of the bonds are traded separately.
f) Floating rate notes
These Treasury bonds have a coupon that fluctuates based on the coupon rate offered by any recently auctioned Treasury bill.
2) Government Agency Bonds
These bonds are issued by some agencies of the U.S. government like the housing-related agencies GNMA or Ginnie Mae (Government National Mortgage Association), or Fannie Mae or Freddie Mac. Government bonds are subject to Federal Taxes but are exempted from state-level or local-level taxes.
The US government agency bonds are high-quality and high liquidity bonds because they are issued by the US Federal government, however, the interest incomes may not keep pace with the inflationary changes taking place in the economy. Some government agency bonds are fully backed by the U.S. Federal government, thereby making them as safe as Treasury bonds.
Housing-related government bonds like the GNMA can be refinanced as mortgages if the interest rates change as mortgages are highly susceptible to changes in the interest rates.
If interest rates rise beyond a certain limit, fewer people will go for the refinancing option, and therefore the bonds that the investors are investing will yield less money but can be later reinvested when the interest rates improve. On the contrary, if the interest rates fall, more investors will opt for refinancing, and there will be more opportunity to reinvest the money at much lower interest rates.
3) Corporate Bonds
Corporate bonds, as the name suggests, are issued by companies. Large companies prefer raising money through stocks and bonds rather than seeking bank loans for debt financing. This is because of various reasons, like large corporations need more funds that can be obtained from banks, and also because bond markets offer more favorable terms and conditions than banks and, most importantly, charge lower interest rates than banks.
However, these bonds can be both super risky and, utmost safe depending on the market conditions during which the bond is issued. Interests from corporate bonds are taxable both at the Federal level as well as at the state level. As corporate bonds are not as safe as the government bonds, they yield more interest rates than government bonds.
“High-yield bonds” are also types of corporate bonds having very low credit ratings (below triple B), which means that companies issue these bonds with relatively weak balance sheets, and therefore are more susceptible to defaults.
4) Municipal Bonds
Municipal bonds or Munis, as they are more commonly called, are issued by local governments and municipalities of a city or states to fund their projects. Interests received from municipal bonds are exempt from Federal taxes, also sometimes from the state taxes if a bondholder resides in the same state where the bonds have been issued. Municipal bonds differ in their creditworthiness; some are more credit-worthy than others, though most of the municipal bonds are insured. Therefore, if the bond issuer defaults in payment of interest rate to the bondholders, then the insurance company will cover the bond amount and the interest that has accrued during the tenure of the bond.
Some other Bonds
Apart from these main categories of bonds, there are some other bonds as discussed hereunder:
1) Savings Bonds
Savings bonds can be redeemed after a year of holding them up to a maximum of 30 years. Currently, there are two types of Savings bonds issued by the U.S. Treasury:
- EE Savings Bonds are those bonds that earn a fixed interest rate and can be redeemed after a year but can be held for up to a maximum of 30 years. However, holding these bonds for less than five years would lead to 3 months of interest loss as per the policies. At the time of redemption, the bondholders receive an amount which is the SumTotal of the interest accrued plus the amount that was paid at the time of purchase of the bond.
These bonds can be purchased either directly from the bank or online. In case these bonds are purchased directly from the bank, the bonds will be in the form of paper certificates for half of their face value in varying increments ranging between $50 to $10,000. But if they are purchased online, they can be purchased at the full-face value.
- I Savings Bonds are another type of savings bonds that are similar to EE savings bonds, with the only difference that these bonds are indexed for inflation after every six months. These types of savings bonds are always sold at face value, regardless of whether they are bought directly from the bank in the form of paper bond certificates or bought online electronically.
2) Foreign Bonds
Foreign bonds are generally foreign currency-denominated debt, where 1/3rd of the assets are denominated in foreign currency. In a foreign bond, the bond issuer or the borrower promises to pay the principal value of the bond along with the fixed interest payments to the lender or the bondholder in another currency. The interest rate would be converted into dollars depending on exchange rates prevailing in the market at the time of issuance of the bonds.
In case the Dollar strengthens against foreign currencies, then the foreign interest payments will be converted into smaller Dollar amounts, and vice versa in case the Dollar weakens. Thus, in a foreign bond, it is the exchange rates that are more dominant than interest rates, as such, the exchange rates will determine the performance of a foreign bond.
Advantages of bond securities over other securities
- Bond securities are less volatile than stocks.
- Bond securities are highly liquid, which means that they can be sold in any quantity, at any time without affecting the price much.
- Bondholders enjoy legal protection, which means if the borrower goes bankrupt, the bondholders will get a portion of the money back.
How do Bonds Work?
Bonds are often referred to as fixed-income securities since the investment grade in bonds earns a fixed income for the lenders over the bond’s entire life. Many corporate and government bonds are publicly traded while others are traded privately or over-the-counter (OTC) between the borrower and lender.
When companies or government entities need to raise money to continue their operations or for financing new projects or for refinancing existing debts, they issue bonds directly to investors. The borrower or the bond issuer issues a bond mentioning the terms of the loan, the interest rate at which the payments will be made, and the period of time after which the loan must be paid back to the lender. The interest rate is also called the coupon rate, and the date when the term of the loan expires is called the maturity date. The interest or the coupon rate is part of the return that bondholders or the lenders of the funds earn for loaning their funds to the borrower.
The initial price of most bonds is set at par, which can be $100 or $1,000 face value per individual bond. The face value is the actual market price of the bond that the lender pays initially. The actual market price of a bond depends on several factors like the borrower’s credit quality, the tenure of the bond, and the interest rate of the bond in comparison to the general interest rate existing in the market at that time. If the bond issuer has a poor credit rating, those bonds will pay more interest as the default risk is higher in these cases. These credit ratings of a company are assigned by credit rating agencies like Filch Ratings, Moody’s, etc. In the event of maturation of a bond, the bond’s face value, along with interest accrued during the bond term, will be paid back to the lender.
Markets allow the initial bondholders to sell their bonds to other investors or even to buy bonds from other investors after they have been issued. This means that a bondholder doesn’t need to hold his bond until the maturity date. Therefore, it is very common for the borrowers to repurchase the bonds if the interest rates decline to a certain extent, or if the borrower is in a position to reissue new binds at a much lower cost due to his credit improvement.
How do bonds work?
Corporates or the government issues bonds in the market to raise huge money for executing their expenses. These bonds are bought by investors who are ready to lend money in return of interests, which are calculated based on the bonds’ terms at the issuance time. After the bond matures, the interest accrued on the bonds, along with the principal value with which the investors had bought the bonds is paid back to them.
What is a bond in simple definition?
In economics, a bond is defined as a debt instrument that is issued by corporations or governments to raise money from the market.Unlike stocks, bonds do not represent ownership in the company, but it represents the company’s debt or organization that issues the bonds.
What are the different types of bonds?
There are four main types of bonds issued in the US market, namely, Treasurys, Government bonds, Municipal Bonds, and Corporate bonds. Apart from these, there are mortgage backed bonds, savings bonds, and foreign bonds.
What is a bond in the market?
A bond is a debt that the bond issuer makes against the investors who lend money for the execution of the organizations’ financial operations for which they issue bonds.