Bonds 1: What would make you want to buy debt?

Susan
By Susan May 30, 2012 08:41

Bonds 1: What would make you want to buy debt?

 

This is the first post in the new series about bonds – make sure to sign up for the newsletter to get the next posts directly to your inbox!

 

Do you like being in debt? How comfortable do you feel with your mortgage payment, with your credit card debt?

 

Individual debt makes people uncomfortable. Most of us don’t like owing money and others see debt as a necessary evil, as a way of getting by because they find they have rather too much month left at the end of their money.

 

But to big institutions, being in a lot of debt is just another day at the office.

 

 

Think of debt as a product to be bought and sold

 

When a government, a company or any other institution chooses to issue bonds (i.e., decides to take out a loan), they prepare an offer: they package their debt with the help and advice of an investment bank, to be sold to a few institutional investors (read: “big players like other investment banks”). This is called the primary market.

 

Once this debt has been sold in chunks, with each chunk amounting to several million or billion dollars or euros, it is then divided up and sold on to other institutions and individuals like you and me: it’s “traded” on the secondary market.

 

When you as an investor buy a bond, you’re not buying it directly from the issuer. Let’s say you buy a bond through a stockbroker: the broker will arrange for that debt security to be sold on to you.

 

So bonds are not a direct loan: you as an individual investor do not lend money directly to a government or a company. Debt is transformed into a financial product that can be bought and sold on an exchange.

 

And there are many different types of bonds, as many as there are different types of debt, multiplied by all the different bells and whistles that a borrower can add (or take away) to make the loan more suitable or tailored for the lender’s desires.

 

 

What would make you want to buy debt?

 

Think of it for a second: if a friend of a not-so-close friend called you up and explained they wanted to borrow €2,000 from you, do you think you would jump at the opportunity? Not exactly. More likely, you would be shocked that they have the cheek to even ask you in the first place. Why would you want to take the risk that they won’t pay you back?

 

This is why debt is positioned to become attractive to potential buyers. Interest payments that step up or move in line with inflation are examples of those bells and whistles.

 

Why would you want to buy a bond then? Because bonds are a very good way of conserving money. Let’s take the example of energy: energy is notoriously difficult to stock. This is why we are so dependent on fossil fuels and making the change to renewable energies is proving such a headache: because fossil fuels are the best way known to man – until now – to stock energy in order to conserve it. Energy stocked in the form of fossil fuels is so stable that it can be, well, as old as a fossil. You can stock it, forget it, and it will be there when you need it. In the case of wind or sun energy on the other hand, you have to use up this energy as soon as it is produced, because it is difficult to stock. In a way, it evaporates.

 

Money, unfortunately, also has a tendency to evaporate, or to erode. This is why you would want to stock it in such a way that it wouldn’t be affected (or as little as possible) by inflation, for example. Earning interest on your money is such a way to avoid erosion: if inflation is 3%, but you earn 4% interest on your money, you are able to keep ahead of inflation. If you just stock money, without it earning any interest, you will find that it ends up being worth less and less.

 

Now you could earn interest by depositing your money in a savings account. In normal times (that is, not in the last five years, or even the last fifteen here in Ireland!),  it is a rare savings account that can do much better than barely keep up with inflation. Savings accounts usually earn you around 3% in interest at the most, while inflation was around 3% for services in February 2012.

 

What if you could get a better return than with a savings account? Bonds might offer you this better return. For example an Irish government bond maturing in 2019 or 2020 might have a yield of over 7% on Tuesday May 29, 2012.

 

Therefore, you can buy a loan, backed by the Irish state, and get this interest rate. The capital gain is tax exempt. On the date the Irish government issued this bond, they obtained the money to fund the deficit (the gap between tax and spending). However, it’s not just a loan where you get your money back and a little more, you also get an annual payment, called a coupon.

 

If you combine the two, you get the “bond yield” – those two words continue to dominate news headlines all over the world….

 

This post is the first in the new series about bonds: if you would like to know more about the bond market, sign up for the newsletter and get updates directly to your inbox!

 

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Next post: Bonds 2: “But why is it called fixed income if the return can fluctuate?”

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Susan
By Susan May 30, 2012 08:41