Real World Economics: Bond primer part 1: Understanding the market

Edward Lotterman Bonds are in the news You may have read that Congress is pushing through a Big Beautiful Bill that will require the U S to borrow even more money via issuing Treasury bonds to fund the larger and ever-growing U S deficit Japan is struggling with bonds that make up its own large national debt China long on the buying side of our bond selling now threatens to sell certain That will force our interest rates up regardless of what the Federal Reserve does How exactly does this all work Bulk people understand that a bond involves specific institution typically a regime or a business borrowing money on which it must pay interest But everything after that becomes a muddle So here is a primer Yes a bond whether sold by a regime or a private business is an IOU or promissory note It legally documents a debt Bonds differ from home mortgages car loans or credit card agreements in that they are very standardized portions of a large borrowing Whether issued by a private corporation school district state or the U S Treasury a bond is the same as thousands or millions of others issued in the same offering The face value or principal the term or the period of time before the principal must be repaid the rate of interest and when it will be paid are specified The collateral or underlying value securing the debt is the capital assets of the seller plus the seller s ability to make money either through corporate profits or taxation authority We say that bonds are bought and sold but the act of buying is authentically lending money Selling or issuing a bond is accepting a loan and making this legal promise to pay But this only applies to the initial issue in a primary industry After that largest part bonds are negotiable or resalable from one person to another before the maturity date U S Treasury Bonds that constitute the national debt are offered in a wide range of maturities that fall into three categories with different names Ones maturing in only and weeks are bills These are like the Series E or EE savings bonds that could be bought for about but for which one received a few years later when they matured Those had no semi-annual or annual payment of interest The difference between the purchase and redemption price was the interest T-Bills work in the same way They are purchased for less than the nominal value that is paid out on maturity The larger the difference between purchase price and redemption value the higher the interest rate earned Treasury Notes currently have maturities of or years Interest is paid every six months to whomever owns the note as of a specific date At this time Treasury Bonds per se are sold only for - and -year maturities Interest is paid twice a year Regardless of the bill versus note versus bond technicalities all debt of the U S executive is generically called Treasury bonds or Treasurys All these are sold in competitive auctions Large financial firms starting with the one offering the lowest interest rate get batches of bonds desired These dealers then sell the bonds on to investors banks insurance companies retirement funds and mutual funds Individuals long had to go through a broker but now can secure bonds for themselves at the majority favorable interest rate for that particular auction Read About Treasury Marketable Securities at treasurydirect gov for an excellent explanation of this Once any Treasury safeguard is purchased it can be resold again and again So can nearly all corporate bonds or ones sold by state and local governments This differs from the primary sphere mentioned above Subsequent bond sales and purchases are in secondary markets Such secondary trading then leads us into questions of how bond markets can force hard decisions on governments and the reasons as stated above that bonds are in the news To understand the dynamics of this consider contracts for deed in which the seller of a house or farm accepts a down payment and the rest of the principal must be paid off over a few period of years Accrued interest is due at the time of each principal payment There is no need for the buyer to get a mortgage and the seller remains vulnerable to any default But the incentive here is that the seller may find more anticipated buyers than through the mortgage process Even though conventional property sales through mortgages predominate such contracts for deed long were common in selling farmland small businesses in rural areas and houses Even though sellers did not get large amounts of cash to purchase another residence or settle an estate and bore the exposure of default contracts for deed suited the circumstances of a few sellers and specific buyers One reason was that it was a explanation for lack of liquidity If you had sold a property on a contract for deed but your situation then changed so you needed cash without delay you could sell the contract to an investor who specialized in such deals You got a lump sum of money They got the legal document giving them rights to collect interest and principal payments People who remember classified ads in hard-copy newspapers may recall sections of these offering CDs bought highest prices and a telephone number The price offered however recognized that the amount of cash a seller would get was less than the amount of principal still owed on the contract If principal remained to be paid you might get cash for signing over ownership The amount of this discount varied greatly with the interest rate Say you had sold a house on a CD in with interest due every year on the outstanding balance Then in with still owing interest rates had risen to You only would find a buyer for that CD if you took a real haircut No one would give you Depending on the number of years left you might get or less The or less depended on this differential between the interest rate in the contract compared to current rates Realizable future rate fluctuations also were a consideration together with riskiness of the buyer and administrative hassles of collecting payments Secondary markets for bonds function in very similar avenues Seasoned bonds that were issued a minimal or a great number of years ago can be readily bought and readily sold Ones issued by different entities Xcel Resource Roseville Society Schools the U S Treasury or the Republica Argentina each have different levels of menace However rating agencies such as Moodys Standard and Poors or Fitch track all relevant variables closely and assign ratings tied to the level of threat Buyers don t grope in the dark How does all of this play out in the effects of China selling off large quantities of U S Treasury bonds bought in the past Who are bond vigilantes and why do interest rates depend on them as much as on the Federal Reserve Remember the situation of someone who owns a contract for deed and requirements cash and come back to this space next week for a further explanation Related Articles Real World Economics Pragmatism not globalist ideology drove U S agreement procedures Real World Economics Tax bill full of perverse incentives Real World Economics Remember the money supply It s our main obstacle Real World Economics GDP is significant but must be kept in context Real World Economics The buck stops Trump or so it appears St Paul economist and writer Edward Lotterman can be reached at stpaul edlotterman com