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Bonds The Other Market
By George L. Fulton
AuthorHouseCopyright © 2005 George L. Fulton
All right reserved.
Chapter OneWhat is a Bond?
We'll start simply. Let's say that you have a friend who has asked to borrow some money from you. He needs one thousand dollars for a year. To entice you to lend the money, he offers to pay you 12% interest on that money for the year. So, you agree and you lend the money to him. In so doing your friend has just created a financial bond with you. Thus, a bond is nothing more than a promise; a promise made by the borrower to repay borrowed money at a specific time and to pay interest for the privilege of the use of that borrowed money. It is much like an IOU.
The money you lend to the borrower is called the "principal." The money the borrower repays you above and beyond the principal amount is called the "interest." In this example with your friend, there are two promises: the promise to pay you 12% interest for the use of your money and the promise to repay the principal in one year. The principal repayment date is called the "maturity" date - the date on which the promise to repay (or the bond) matures. Within those promises there may be some conditions. Your friend may agree to pay you the full 12% interest in one lump sum at the same time that he repays you the principal (the maturity date). He may agree to pay you one half of the interest in six months and the other half at maturity. He may agree to pay you one quarter of the interest every three months with the final payment at maturity. Maybe he agrees to pay you one twelfth of the total interest every month. Whatever the interest payment arrangements, the dates on which interest is to be paid are called "coupon" dates.
We have to digress just a little to discuss coupons. In days gone by, bonds were issued with physical paper coupons. In order to collect your interest payment you had to go to the borrower and physically hand over your coupon which had the interest rate printed upon it. The payer would then calculate the amount of interest due and pay accordingly - no coupon, no payment. Nowadays, bonds are no longer issued with paper coupons and you don't have to go anywhere to demand payment. It's all done electronically and automatically. We still use the word "coupon" but it has taken on a whole different meaning in the modern era. In the example with your friend in which he agrees to pay you 12% interest for a year, that 12% is now referred to as the coupon. That 12% is the number that would have been printed on the paper coupon in olden days. By the way, interest is always expressed on an annualized basis. If your friend had agreed to repay the money in two years at a 12% interest rate, that would be 12% per year for two years and the coupon would still be 12% not 24%.
There is one exception to this idea of the coupon being equal to the interest payment on the bond - the zero coupon bond. It doesn't follow that you would lend money to someone for a year or more and not expect to receive some interest. After all, that interest is your reward for having taken on the risk of lending your money in the first place. How could you lend your friend some money, not receive interest payments and still be rewarded for your effort? Let's see, 12% of one thousand dollars is one hundred twenty dollars. Instead of lending one thousand dollars, you lend eight hundred eighty dollars (one thousand minus one hundred twenty). Your friend accepts the eight hundred eighty dollars and agrees to pay you one thousand dollars at maturity in one year. You still receive a 12% return but it is all considered principal. In effect your friend has simply borrowed money at a discount and has agreed to repay it at full value hence, there is no agreed upon interest rate, no coupon or a "zero coupon." Obviously, had you agreed to lend the money for two years it would have to be at a deeper discount in order for you to realize a 12% annualized return. Specifically, you would lend seven hundred sixty dollars with the agreement to be repaid one thousand dollars in two years. At maturity you will receive two hundred forty dollars more than you lent - 24% over the period of two years or 12% annualized. Remember, I am using easy math here to demonstrate a concept.
Thus far in our story we have a borrower who is also the one who promises to repay. He is also therefore, the issuer of the bond. We have a coupon - the annualized rate of interest the borrower will pay for the use of your money, and we have a maturity date - the date when your principal will be returned to you by the borrower (let's assume a maturity date of 12/15/05). This gives us enough to describe the bond in the way in which most bonds are described: the name of the issuer (sometimes called the "label"), the coupon and the maturity date. Let's say your friend's name is John Doe. The bond he issued to you would be described as "John Doe, 12%, 12/15/05." You could further describe the bond by how it pays interest: it pays monthly or quarterly or semi-annually or at maturity.
Let's talk about this whole concept of borrowing and lending, coupons and methods of repayment. Remember first and foremost that a bond is nothing more than a promise to repay a debt. For that reason, the market in which bonds are bought and sold - the bond market - is sometimes, though not frequently, called the "debt market." Because bonds generally, though not always, have a fixed rate of return or fixed coupon, the bond market is more frequently referred to as the "fixed income market." In all bonds, the promise to repay the debt is only as good as the credit worthiness of the borrower. For this reason, the bond market is generally referred to as the "credit market." However referred to, the promise to repay is implicit. The strength of that promise is a function of the credit worthiness of the borrower. The less credit worthy, the more interest the borrower must pay because the lender is taking on a greater risk that he may not be repaid. On the other hand, the greater the credit worthiness of the borrower, the less he must pay in interest because the lender is accepting a lesser degree of risk. Now, let's substitute the words "issuer" for borrower and "investor" for lender.
The value of any investment is a function of risk versus reward. As an investor, your tolerance for risk determines the level of credit worthiness you would seek in an investment and that level of credit worthiness determines the level of return on your investment. The greater the risk the greater the reward. To say it a different way, on any given day any number of issuers may be competing for investors' money. Those with the best credit ratings will be able to offer lower coupons than those with lesser credit ratings.
This whole concept of credit worthiness also plays into how frequently issuers pay interest on their bonds. Think about this for a moment, you have just invested a thousand dollars into a bond. How would you feel if you were not to hear from the issuer until maturity? Would you wonder every so often about how the issuer is doing? How safe is your investment? Wouldn't you feel just a bit more comfortable if the issuer made an interest payment to you every six months? At least you would have the idea that the issuer is financially OK, for the time being anyway. How much better would you feel if the issuer paid you every quarter? Or better yet, every month? The more frequently the issuer pays you, the more assurance you have of the financial soundness of the issuer. As an investor, that's a good thing. As an issuer, using the promise to pay monthly may allow for a cheaper borrowing cost (lower coupon) than might otherwise be possible. In this "risk versus reward" equation, the words "certainty" and "uncertainty" come to mind. The more certain that the issuer will honor its debt, the less risk is involved and therefore the less the return on the investment. In general, the greater the uncertainty the greater the risk. This goes for individual issuers and whole markets as well. In fact, it is the fundamental and seminal difference between the bond and stock markets.
When you buy a stock you are actually buying a share in some company. Whether or not the company ever pays you a dividend is totally dependent upon how well the company does. Whether the stock price advances (goes up) or not is based on the perceptions of other investors and analysts. Those perceptions are based on a myriad of circumstances over which, it often seems, no one has any control. There is absolutely no promise that you will ever get your principal back let alone make money. There is, in fact, every possibility that you will lose money. This tremendous uncertainty, this tremendous risk of losing your investment is, in many investors' minds, offset by the potential for huge returns. The bond market, on the other hand, is founded on the fundamental premise that you will get your money back - with interest and on a date certain. This relative certainty, in general, is why the bond market will return less than the potential returns of the stock market. It's all a matter of risk versus reward.
Chapter TwoWho Issues Bonds and Why?
Bonds are issued by governments (state, local, federal and foreign); corporations (domestic and foreign); agencies, authorities and enterprises of governments (state, local, federal and foreign); and even individuals. Treasury bonds are an example of bonds issued by the U.S. Government. Municipal bonds are issued by a municipality or the municipal authority of a local or state government. Corporate bonds are issued by, you guessed it, corporations either foreign or domestic.
All of these entities issue bonds because they need money, now. What they are doing is borrowing money now so they can do something with it, with the promise of repaying it at some future date. Let's take the case of a bridge and tunnel authority that wants to build a toll bridge across a very large river in order to ease traffic congestion. The anticipated cost of the toll bridge is fifty million dollars. The bridge and tunnel authority has three choices. It can pay in cash out of its own coffers (not likely). It can assess a special tax on the persons over whom it has taxing authority (this will certainly make some taxpayers unhappy, especially those who don't drive). Or it can issue a bond counting on the revenue produced by the toll bridge to pay off the bondholders at maturity with enough money left over to provide for ongoing bridge maintenance. More than likely the bridge and tunnel authority will issue a municipal bond for the amount of money they need. As an investor you should immediately be thinking "what are the chances they will ever have fifty million dollars to repay in one lump sum?" Chances are they won't. What they may do instead is issue a series of five bonds in which ten million mature every five years for the next twenty-five years. Five payments of ten million dollars each spread over twenty-five years is much easier to handle than any single payment of fifty million dollars no matter when it occurs.
The federal government has two major sources of revenue: taxes and bonds. When government spending exceeds the revenue raised by taxes the government covers its shortfall by issuing bonds. What the government is doing is borrowing money from investors, money that must be repaid at some later date, but in the process it is making ends meet. The total of all of the bonds outstanding is known as the national debt. Don't confuse the national debt with budget deficit. The deficit is the amount of shortfall in any single year as measured against the revenue for that year. Since revenue (tax receipts) is always an anticipated number (the government has no way of telling who is going to pay how much in taxes - or when - its all pretty much a guesstimate based on historical data) the deficit is generally thought of as the amount of money appropriated by Congress for spending in any given year against the operating budget for that year. In order to cover the shortfall, the government can curtail spending (not likely), increase taxes and penalties (ouch), borrow the needed funds from some program that may have a surplus (retirement funds come to mind), or it can issue bonds, Treasury Bonds. The cumulative total of all the outstanding bonds issued by the government is the national debt. That is the amount of money the government owes to investors ($7,142,411,925,184.34 as of this writing). How the government manages that debt is rather interesting. Let's say that this month fifteen billion dollars worth of government bonds are due to mature. The government has to pay that money out. To raise the funds for that payment, the government will generally hold a bond auction to issue new bonds - no doubt you have heard of the quarterly refunding. If the government holds a ten billion dollar auction against a fifteen billion dollar maturity, it is actually paying down the national debt by five billion dollars. If it holds a twenty billion dollar auction against the maturity, it is actually increasing the national debt by five billion. All of this occurs every week, every month and every quarter and goes virtually unnoticed by the average citizen. Most citizens have absolutely no concept of what the national debt is, how it is managed nor its magnitude. By the way, the national debt does not include the debt created and carried by Government Agencies and Government Sponsored Enterprises - debt for which the government is either directly responsible or, in the cases of Government Sponsored Enterprises, indirectly responsible.
Among the Government Agencies (and Government Sponsored Enterprises - GSEs) which routinely issue debt instruments (bonds) is the Government National Mortgage Association - GNMA - most often called Ginnie Mae - a wholly owned US Government corporation within the U.S. Department of Housing and Urban Development (HUD). Ginnie Mae was formed to ensure liquidity for U.S. Government insured mortgages including those insured by the Federal Housing Administration (FHA), the Veterans Administration (VA) and the Rural Housing Administration (RHA). FHA mortgagors are typically first-time, lower income homebuyers (why this is important later). The GNMA guarantee carries the "full faith and credit" of the US Government in terms of guaranteeing the timely payments of principal and interest and is considered to be the safest of federal agencies.
The Federal Home Loan Mortgage Corporation - FHLMC - most often called Freddie Mac - is a GSE (Government Sponsored Enterprise) that routinely issues bonds. Freddie Mac was created in 1932 (after many banks had failed due to the great depression) to supply credit reserves for savings and loan associations, banks and other mortgage lenders. Because Freddie Mac is a GSE, it is not backed by the "full faith and credit" of the government but rather by the "full faith and credit" of the enterprise itself and the "implied faith and credit" of the government. This "implied" guarantee results from a credit line extended by the government to the enterprise. Though the credit line has never been used (as of this writing), the fact that the enterprise has virtually direct and immediate access to the funds of the U.S. Government implies that all of its debt obligations will be met, thus, Freddie Mac issues (bonds) carry the same investment ratings as bonds issued directly by the government.
The Federal National Mortgage Association - FNMA - most often called Fannie Mae - is a government sponsored corporation that issues bonds. Chartered in 1938 to purchase mortgages from lenders and resell them to investors, the agency packages mortgages backed by the Federal Housing Administration (and some non-government backed mortgages). As a Government Sponsored Enterprise (GSE). the guarantee of Fannie Mae bonds is the same as those of Freddie Mac.
The Federal Home Loan Bank - FHLB - most often called the Home Loan Bank - is a GSE created in 1932 for similar reasons and purposes as Freddie Mac. The FHLB issues bonds that have the same guarantees as those of Freddie Mac and Fannie Mae.
There are several additional GSEs which periodically issue bonds and which carry the "implied" faith and credit of the U.S. Government. Among them are:
The Federal Farm Credit Bank - FFCB
The Tennessee Valley Authority - TVA
The Federal Agricultural Mortgage Association - Farmer Mac
The Financing Corporation - FICO
The International Bank for Reconstruction and Development - World Bank
Private Export Funding Corporation - PEFCO
There are a few other agencies and Government Sponsored Enterprises (GSEs) that issue bonds but the frequency and/or size of their issues is so infrequent or small as to make the bonds illiquid (difficult to sell because they represent such a small portion of the market) thus, they will not be mentioned here. Even a few of the last six agencies listed above are rapidly approaching illiquidity because either their purpose has been outlived (or is approaching the end of its life cycle) or the volume of bonds they issue has decreased substantially over time.
Here is a tidbit for you - it occurred to me because I just mentioned "time" - the difference between bills, notes and bonds is time. Perhaps you didn't know that there are such things as bills and notes - well, there are and they are exactly the same things as bonds but the difference among the three is time. Bills are issued with a maturity date of one year or less. Notes are issued with maturities of between one and ten years. Issues longer than ten years are called bonds. Just as children, teenagers and adults are classifications of human beings by age, so too bills, notes and bonds are classifications of debt instruments by their age at maturity. The only significant difference among the three, aside from maturity dates, is that bills typically do not make periodic interest payments. Instead, they are either bought at a discount to mature at par (100 cents on the dollar just like zero coupon bonds) or they pay interest at maturity.
Excerpted from Bonds The Other Market by George L. Fulton Copyright © 2005 by George L. Fulton.
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Most Helpful Customer Reviews
This book covers what you really 'need to know' about bonds and how they differ from stocks. It is written in plain English and is unlike any other book on the topic. It is concise yet packed with useful information. The book covers the entire topic in a logical, straight-forward progression of concepts that are easily grasped. Beyond being fully indexed, each index entry is presented in boldface throughout the text of the book thus making it a ready reference resource for novice and pro alike.