Two Minute Tips

Financial market reporting, part 4: Bonds and bond markets

January 5, 2017

Share this article:

Historic gold bond with coupons attached. (Copyright George H. LaBarre Galleries Inc., used by permission)
Historic gold bond with coupons attached. (Copyright George H. LaBarre Galleries Inc., used by permission)

Bonds gets no respect. It’s not clear why. For many companies, institutions and investors, bonds are the vehicle of choice.

Companies generally issue stock to the public to raise money. In issuing stock, companies give up ownership of the firm to shareholders, who share in future profits and growth. They also share in the risk if company should fail, or at least not live up to expectations. Not every investor is comfortable with that prospect.

Risk-averse investors want more of a sure thing. Stuffing cash into your mattress avoids the risk of company failure. But there are other risks, theft being the obvious one. A nice, government-insured certificate of deposit at your local bank sounds good. But as of this writing interest rates on CDs are so low buying them doesn’t seem worth the effort.

Fixed income investments

Both CDs and bonds are like loans and are called fixed income investments. Where CDs are generally issued by banks, bonds are issued by companies, governments and many quasi-governmental institutions. While a government-insured CD has virtually no risk of default, bonds carry a default risk correlated with the likelihood that the issuer will be able to pay the interest and return the principal.

The United States Government is constantly issuing debt securities to finance spending. The term “bond” is generally used for a loan lasting more than ten years. “Notes” are issued for one to ten years and bills are short-term loans lasting less than one year. Short-term U.S. government obligations are often called treasury bills or “T-Bills”.

The United States is considered the world’s best borrower. It has never defaulted on its debt. That helps make the U.S. dollar the world’s favorite reserve currency and allows the United States to borrow at the lowest cost. Treasury instruments are usually called “risk-free” investments. The 10-year treasury note is the benchmark most often used for comparison with other investments. If you can’t beat the return you get from putting your money into a 10-year treasury, why would you buy something with more risk?

The U.S. Treasury auctions 10-year notes almost every month. You can buy them directly by setting up an account at Treasury Direct or through your bank or broker. Individuals usually make “non-competitive” bids, meaning they take the interest rate arrived at through an auction process in which large investors specify the minimum interest rate they will accept. For example, you might buy a $10,000 10-year note paying $300 in interest each year. That gives you a steady stream of income, which explains the term “fixed income” investment. $10,000 is the principal or face value, 3 percent the interest rate or “coupon,” and 10-years the term.

The greater the risk….

State and local governments and local institutions, such as school districts and transportation authorities, are authorized to issue bonds in order to raise money. Private companies also raise capital by issuing debt. In considering which to invest in, investors consider the previously mentioned risk of default. Bond-rating agencies like Standard & Poor’s and Moody’s  provide estimates of the risk for fixed income securities. But the bond issuer usually pays the ratings agency for this service, which has raised concerns over conflicts of interest. In case of default a bond holder is generally at the head of the line when it comes to being a creditor in bankruptcy court. Stock holders are at the end. Bond holders often get smaller payments than originally expected, say 50 cents on the dollar, but they get something. This is known by the poetic term “taking a haircut”.

The riskier the investment, the more the borrower must offer as an incentive. This is reflected in the interest rate the borrower offers. It can be said that the interest rate is the “price” of money. The greater the yield, the greater the risk.

Quirks and complications

It is all pretty straightforward for a fixed-rate investment held to maturity. But things can get complicated very quickly as there are all kind of variations on the theme, such as bonds that pay all their interest at maturity, or zero-coupon bonds that pay no interest but are sold at less than face value (at a discount). And there is a possibility that a bond holder will want to trade her bond before its maturity date. This requires a net present value calculation, taking into account the current yield to maturity, the coupon rate compared to the current interest rate (they fluctuate continually) and changes in risk factors. Bonds are traded broker-to-broker through a computer trading system. That means there is no trading floor and no bond exchange with a single physical location.

In our next post regarding standard investment opportunities, we’ll cover commodities and other “real stuff”, and futures contracts.

Reporter’s Takeaway

• Bonds are a form of “fixed-income” investment, like a loan, providing an income stream over time.

• The U.S. Government is the world’s largest issuer of bonds and has never defaulted on its debt.

• Bonds are bought and sold through dealers using a computer system, not on a trading floor.

More Like This...

three people sitting at a table reviewing graphs and charts

The ABCs of funding rounds

Someone might have a great idea for a startup, but it’s not going to go anywhere without money. Initially, investors will start a business with their own savings or borrow

three people presenting to a group of executives in an office

Experts’ tips for evaluating startups

Covering startups can be exciting and frustrating all at the same time. The newest billion-dollar startup can become the hottest topic in the business and tech media overnight, and its

Two Minute Tips

Sign up now.
Get one Tuesday.

Every Tuesday we send out a quick-read email with tips for business journalism.

Subscribers also get access to the Tip archive.

Get Two Minute Tips For Business Journalism Delivered To Your Email Every Tuesday

Two Minute Tips

Every Tuesday we send out a quick-read email with tips for business journalism. Sign up now and get one Tuesday.

Our New Look
The Reynolds Center for Business Journalism is starting 2023 with a new look that we hope better illustrates our core mission to provide accurate and authoritative resources about business journalism, in order to help both reporters and news consumers understand the importance of business news and to demystify the sometimes arcane topics it covers.
Businesses, markets, and economies move in cycles – ups and downs – which is why our new logo contains a “candlestick” chart representing increases as well as downturns, and serves as a reminder that volatility is an unavoidable attribute of modern life. But it’s also possible to prepare for volatility by being well informed, and informing the general public to help level the information playing field is the primary goal of business journalism. The Reynolds Center is committed to supporting that goal, which is why the candlestick pattern in our logo merges directly into the name of our founding sponsor, Donald W. Reynolds.
Our new logo comes with a shorter name. Business is borderless, and understanding the global links in supply chains, trade, and flows of funds and people is essential to make sense of our fast-paced, globalized world. So we’re dropping the word “National” from our name and will aim to provide content that is applicable to business news globally.
We hope you like the new look. Best wishes for 2023!