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Bonds are in the news. But what exactly is happening? – Twin Cities


Edward Lotterman

Bonds are in the news – and their swings in yields and prices influence stocks and the economy as a whole.

But even those who understand what is happening may have difficulty explaining how it affects the “real world” in which you and I live.

“Volatile bond market; » “Bonds react to GDP numbers; » “Yields and prices fluctuate in bond markets” are all the recent headlines. But what does all this mean?

Unfortunately, this can be a bit confusing, even for well-educated and financially literate members of the general public.

What is the exact “price” of a bond and how can it fluctuate? What is the “yield”? Is it different from the interest rate on a bond? What is an “obligation” itself?

And how is a corporate bond issued by Boeing, for example, different from a stock of Boeing stock? How is a bond different from a CD? What is a “bond fund”? And what is a US Treasury “bond” or “note” as opposed to a “bond”?

It’s time for an introduction.

A bond is, fundamentally, a loan. When you buy it, you’re essentially lending the seller money with the promise that it will be paid back with interest later. This differs from a promissory note, typical of auto loans or mortgages, in that the bonds are not “amortized” over time with periodic payments of principal in addition to interest. And a bond must meet specific financial and legal specifications that a consumer loan or poker table IOU does not need.

The common links are quite simple. You lend me $1,000 on November 1, 2023. I give you a piece of paper promising to pay you $50 each on November 1 for the next nine years and $1,050 on November 1, 2033. The $50 payments represent a 5% interest on $1,000. of the director. The remaining $1,050 also repays the amount originally borrowed.

This is a “coupon bond”. There is a variation: you lend me $950 and in a year I pay you $1,000. This is $950 principal and $50 interest. This is a “discount bond”. If it is short term, say 13, 26 or 39 weeks to maturity, it may be called a “bill”, as in “Treasury bills” or “Treasury bills”.

Many people over 50 are familiar with discount bonds, such as U.S. Treasury Series E Savings Bonds, that they received in their youth. These began as war bonds from World War II. Patriotic citizens paid $18.75 for a war bond. Ten years later, they could buy it back and get $25. This was a very low interest rate, so even though the purchase price of $18.75 remained, the time until maturity was shortened several times.

When we talk about “national debt,” we mean bonds issued by the U.S. Treasury. Technically, if they have a maturity of one year or less, they are “bonds”, if they have a maturity of two to ten years, they are “notes” and if they are more than 10 years old, they are obligations. Bonds typically have maturities of 20 or 30 years, but they can be any maturity. Until 1911, cards lasting 50 years were issued.

In addition to the federal government, bonds can be “issued” or “sold” by state and local governments, businesses, and a myriad of entities. Historically, corporate bonds were intended for the construction of major private infrastructure such as steel mills, refineries, mines or factories. “Municipal” – a catch-all for state and local government bonds – was for roads, bridges, schools, or common-use water and sewer systems.

Another thing that distinguishes a bond from a promissory note is that a bond must meet strict legal criteria and disclosure requirements and must be “underwritten” by a qualified institution. This is why when congregations building new churches borrow money from the community, they can issue “promissory notes,” but not “bonds.”

That’s it for the basics. If everyone who lent or invested money by purchasing a bond held it until maturity, that would be it. But people change their minds and some need cash before a bond matures. And there are always speculative investors looking for returns in every possible situation. Thus, bonds are also trading instruments in the securities markets.

And this is where the complexity sets in.

Suppose a poor fatherless child, like me in 1950, received an inheritance of $1,000 from his deceased father. And let’s say a state law requires that these funds, held in trust, be placed in ultra-safe U.S. government bonds. Suppose these bonds pay 1.75%, but later the new government bonds pay 4% and 5%. Once the child grows up and wants to sell the bonds early, wouldn’t he or she rather receive $40 or $50 per year over the life of the bonds instead of $17.50?

If the money is stuck in 1.75% bonds, the only way to find a buyer before the bonds mature would be to offer them at a price below “par”, or the face value of $1,000. With this substantial “discount,” the bond’s yield would be competitive with newly issued bonds at 4%-5%. The market “price” of the bond could be $600 compared to the “par” of $1,000. The “coupon” or nominal interest rate would still be 1.75%, but the yield – or the difference between value and price – would be, say, 4.5%.

Consider someone who purchased a $1,000 30-year Treasury in 1981, when the Federal Reserve was crushing inflation with sky-high interest rates. With a 14% coupon rate, they receive $140 per year for 30 years. Now suppose that in 2002, after years of low inflation and the post-9/11 Fed pushing interest rates to 5%, the bondholder needs cash. But the bond is still nine years from maturity. Should the holder take $1,000 from the first buyer who offers it? Of course not: $140 a year is worth more than $50. They could get a substantial “premium” over face value. The “price” of the bond would be several hundred dollars higher than the face value. The “yield” or effective interest rate earned by the new owner on his down payment would be approximately the same as on all other bonds of similar risk.

There is therefore an inverse relationship between the price of “seasoned” bonds bought and sold on “secondary markets” and interest rates. If interest rates rise, the yield on new bonds will be slightly higher than on existing bonds, so the price of all existing bonds that mature at the same time, regardless of issue date and initial duration, will decrease. If interest rates fall, the yield on new bonds will be slightly more competitive with that of bonds already on the market and the price of existing bonds will therefore increase.

And that brings us to what is happening now. As economic news, such as the strong third-quarter GDP announced Thursday, or rising oil prices or the Fed’s strategy, is released, market expectations cause interest rates to move in response. Higher rates lower the value of existing bonds offering a specific payment. Lowering current interest rates increases their value.

Likewise, inflation reduces a bond’s “real” or inflation-adjusted yield. So, higher inflation lowers bond prices, and lower inflation raises them.

Understand that even “professionals” sometimes mix up. With the current high uncertainty, prices and yields are yo-yoing compared to normal fluctuations.

A recent Bloomberg News article claimed that “‘the world’s safest asset’ proves anything but….” Fake! U.S. Treasury bonds are the safest investment in the world because the interest and principal promised when the bonds were originally issued have always been paid on the specified date. But no intelligent financier would ever think that if you sold a bond between its initial issue and maturity, you would get the exact face value. This is obvious nonsense.

But market demand for various bonds also determines yields and also reacts to economic expectations announced in the news.

For example, there are different levels of risk for 13-week or 30-year loans, and so bond interest rates will vary depending on the duration of the bond. Traditionally, because there is less risk of something significant changing within a few months, the shorter the duration, the lower the risk and the lower the return. If you plot the rates of various long- and short-term bonds against their maturity, you get a “yield curve.” Generally, because short-term interest rates are generally lower than long-term interest rates, the curve slopes up along a “normal yield curve.”

But if conditions cause people to expect interest rates to fall, short-term rates will sometimes be higher than long-term rates. This is an “inverted yield curve” that has historically preceded a recession. The details on this must be left for another day.

St. Paul economist and writer Edward Lotterman can be reached at stpaul@edlotterman.com.


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