Everything Everywhere Daily: History, Science, Geography & More - Bonds and the Bond Market

Starting point is 00:00:00 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. What if your perceptions about the past, were wrong. Throughline is a podcast that takes you back in time to uncover the parts of the story that may have gone unnoticed. It effectively turned day into night and how it shaped the world

Starting point is 00:00:55 now. Time travel with us every week on the ThruLine podcast from NPR. One of my favorite quotes of all time comes from the political strategist James Carville. His nickname is the Rage and Cajun. He was a campaign manager for Bill Clinton back in 1992. In the early 90s, during the start of the First 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, quote, I used to think that if there was reincarnation, I would want 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. End quote. So what exactly did he mean when he said the bond markets can intimidate everyone.

Starting point is 00:01:48 Well, before we can answer that question, let's start at the beginning and address exactly what bonds are. Let's say you are a company or a government and you 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 in price. Selling shares isn't an option for governments, however.

Starting point is 00:02:17 If they want to raise money, then they have to take the other path, which is also open to corporations, issuing debt. Small businesses and consumers usually take out a loan from a bank. They go to the bank, talk to the loan officer, and make their case. The bank may then give them a loan, which they have to pay back with interest. That's one way to get money through debt. Another option, which is 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 issues the bond.

Starting point is 00:02:53 The borrower, also called the issuer, promises to pay back the principal, the original amount borrowed, on a specific future date called the maturity date. And 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 coupon and then turn them in for your interest payment. These old-style bonds were known as bearer bonds.

Starting point is 00:03:24 The bond was owned by whoever held the physical piece of paper. They're rarely issued anymore because they turned out to be an excellent way to launder money. But they're still used as plot devices in some movies. With bearer bonds, there isn't just a risk of the issuing institution not paying out, but also the physical risk of losing the bond itself. Here's an example of how a normal bond issue might work. Imagine a government needs to raise money for some infrastructure project. Instead of raising taxes or cutting spending,

Starting point is 00:03:56 it issues a 10-year bond with a face value of $1,000 and a 5% annual coupon rate. And they may issue as many of these bonds as is necessary to raise the amount of money that is needed. you, the investor, would buy the bond for $1,000. Each year you receive $50 in interest payments, as $50 is 5% of $1,000. After 10 years, you then get back your original $1,000 investment that you put in. So over the life of the bond, you've earned $500 in interest and you got your money back. Instead of working with banks, as you would alone, the issuing institution would sell these bonds on the open market, and they could be purchased by anyone. So far, this isn't too different

Starting point is 00:04:47 than a standard loan other than who is doing the lending. What makes bonds different than loans from a bank is that they can be bought and sold on secondary markets, just like stocks. And this is the bond market. If you don't know much about bond markets or bond trading, your first instinct may be to question why they exist at all. Stocks can keep going up in value without any real limit. A bond, on the other hand, has all of its terms already baked in. In the example I just gave above, the amount you can get in interest can't change, and the amount you get at the end of the term can't change, and the term can't change. So what's 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're

Starting point is 00:05:36 unable to buy it in the initial auction, you'd have to buy it from someone else in the secondary market. But more importantly, the value of a bond is highly dependent on interest rates. In the above example I gave, the bond had an interest rate of 5%. Let's say that interest rates now go up and people can buy bonds that have an interest rate of 6%. Who would want to own a bond that pays 5% when you could have one that pays 6%. The answer, is, 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 that you sell the bond for. Yield is the word that refers to the return and investor gets from a bond.

Starting point is 00:06:24 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 the purchase price and the face value. In my example, the yield to maturity of a 10-year $1,000 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 at a cost. It might sell for only $950 to match the new higher yield. and I'm assuming that no coupons have been issued yet in this scenario just to make the math easy. By the same token, if interest rates fall, that 5% bond is now more valuable.

Starting point is 00:07:14 Yields are one of the most confusing things about bonds and the bond markets. So pay attention because this is one of the most important things you'll learn in this episode. 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. And there are a host of things that can affect bond prices. If the central bank is expected to raise interest rates,

Starting point is 00:07:47 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, which is an increase in the supply of bonds, or reduced investor appetite, a reduction in demand, can also push yields higher.

Starting point is 00:08:12 Not all bonds and bond issuers are created equal. Some bonds issued by local governments, called municipal bonds, have tax-free interest, which means that they can have lower interest rates to compensate. 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 Computer, which is flush with cash, is issued a bond.

Starting point is 00:08:46 They got 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 risks. These are often known as junk bonds. Junk bonds are high-yield bonds issued by companies with lower credit ratings. Credit agencies typically rate junk bonds below investment grade. Michael Milken, who is working at Drexel Burnham-Lambier in the 1970s and 80s, famously revolutionized the use of junk bonds. He saw an overlooked opportunity. Companies with low credit ratings weren't necessarily.

Starting point is 00:09:29 doomed to fail, they were often just 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, 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 issuers financial statements, cash flow, debt levels, business environment, and economic conditions. The resulting ratings

Starting point is 00:10:10 range from high grade indicating low risk of default to speculative or junk status indicating higher risk. Bon ratings are usually assigned as follows. Triple A, double A, single A, triple B, double B, single B, triple C, double C, and C. And some agencies also have a D rating. Investors use these ratings to assess risk and determine appropriate interest rates for lending. While ratings agencies play a crucial role in financial markets, they've also faced criticism, especially during the 2008 financial crisis, for giving high ratings to risky securities and for potential conflicts of interest, since the issuers of a bond often pay for their own ratings. I want to end the episode by discussing the 800-pound gorilla in the bond world,

Starting point is 00:11:02 the United States government treasury bonds. The U.S. 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 in bonds issued by the United States Treasury Department that are outstanding. Of that, the federal government currently pays over $1 trillion annually in just 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 that are issued by the U.S. Department of the Treasury. And they're all fundamentally the same thing.

Starting point is 00:11:42 They only differ in their maturity lengths and how they pay interest. Treasury bills, or T-bills, are short. short-term securities that mature in one year or less. They do not pay periodic interest. Instead, they're sold at a discount to their face value, and then the investor receives the full face value at maturity. Treasury notes or T-notes have intermediate term maturities ranging from two to 10 years. They pay a fixed rate of interest every six months until maturity. Treasury bonds, often called T-bonds, are long-term instruments with maturities greater than 10 years, typically up to 30 years. Like T-notes, they pay semi-annual interest and return the face value at maturity.

Starting point is 00:12:27 But due to their long duration, T-bonds are most sensitive to interest rate changes and inflation expectations. A savings bond is the same thing, except that it's sold in smaller units, so it's 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 the long-term interest rates. This inversion typically reflects investor expectations that the economy is heading for a slowdown or a recession. Old bonds are constantly coming due, and new bonds are always being released.

Starting point is 00:13:17 The new bonds are often sold to cover the cost of redeeming the old bonds. Going back to the original premise of this episode, bond markets are so powerful because they can increase or decrease bond yields, which forces the government to offer higher or lower interest rates to stay competitive, which means that they have to pay more or less money for their debt. 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.

Starting point is 00:14:00 All U.S. government debt is denominated in U.S. dollars, and the government can produce as many dollars as it wants. This effectively is what's happening when the Federal Reserve buys bonds that can't be sold at auction. However, this isn't necessarily a good thing, as instead of defaulting on the debt, they're just debasing the entire money supply which affects everyone. I'll probably be doing a full episode on the federal debt at some point in the future. Bonds and the bond market are an extremely important part of the global economy. And one of the big reasons they're so important is that the markets can quickly, change bond yields, which then exert powerful influence over governments and public policy. The executive producer of Everything Everywhere Daily is Charles Daniel. The associate producers are

Starting point is 00:14:52 Austin Oaken and Cameron Kiefer. Today's review comes from listener D-Dood 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 guerrilla warfare. Thanks, dude. is that I definitely have some episodes that touch on both the subjects of guerrilla warfare and espionage. I don't have any timeframes on them, but they are on the list. Remember, if you leave a review or send me a boostagram, you two can have it read on the show.

Everything Everywhere Daily: History, Science, Geography & More - Bonds and the Bond Market

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