Bonds and Income

In finance, a bond is a negotiable certificate that acknowledges the indebtedness of the bond issuer to the holder. It is negotiable because the ownership of the certificate can be transferred in the secondary market. It is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest (the coupon) to use and/or to repay the principal at a later date, termed maturity. A bond is a formal contract to repay borrowed money with interest at fixed intervals (semi annual, annual, sometimes monthly).

Thus a bond is like a loan or IOU: the holder of the bond is the lender (creditor), the issuer of the bond is the borrower (debtor), and the coupon is the interest. Bonds provide the borrower with external funds to finance long-term investments, or, in the case of government bonds, to finance current expenditure. Certificates of deposit (CDs) or commercial paper are considered to be money market instruments and not bonds.

Bonds and stocks are both securities, but the major difference between the two is that (capital) stockholders have an equity stake in the company (i.e., they are owners), whereas bondholders have a creditor stake in the company (i.e., they are lenders). Another difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely. An exception is a consol bond, which is a perpetuity (i.e., bond with no maturity).

Although the stock market often commands more media attention, the bond market is actually many times bigger and is vital to the ongoing operation of the public and private sector.

The 1987 Stock Market Crash was because of the BOND Market CRASH:

Some technical analysts claim that the cause was the collapse of the US and European bond markets, which caused interest-sensitive stock groups like savings & loans and money center banks to plunge as well. This is a well documented inter-market relationship: turns in bond markets affect interest-rate-sensitive stocks, which in turn lead to general stock market turns.

Examples of interest rates sensitive stocks are Banks and Auto Makers.

Recent history is rife with periods when the price of risk failed to reflect obvious financial realities. In 2000, we watched technology-stock valuations reach stratospheric highs where entirely new valuation metrics were invented to justify prices. By early 2003, tech-stock prices had plunged more than 60 percent.

In January 2007, with the housing bubble at absurd proportions (home price-to-rent ratios reached levels never seen before) the VIX closed at less than 10, the lowest since December 1993. It took 18 months, but ultimately stock markets buckled and the VIX surged to 80 as credit risk and mortgage securities underwent a wrenching global repricing.

Of course, most recently, the market was forced to acknowledge that it had badly mispriced the risk in European sovereign debt, leading to a three-year fire drill of summits, intervention measures and bailouts.

Policy makers should take caution from these recent periods of financial history. The important point is that the price of risk can sometimes stray from fundamentals.

In the U.S., a yield of less than 2 percent on 10-year Treasuries is entirely disconnected from the fiscal challenges in plain sight and the poisonous debt-ceiling showdown that could be in the offing. Treasuries are a bad deal for most investors, supported only by the easy-money policies of Fed Chairman Ben Bernanke. Other asset classes look like a less-bad proposition, and the need to generate returns in such a low- yield environment could lead to disastrously unsound financial decision making.

In the old days, bond-market vigilantes were around to enforce fiscal and monetary discipline. If the Fed increased the money supply too fast, bond traders were there to keep the central bank in check. When the U.S. ran big deficits, the vigilantes either sold their holdings, or threatened to sell, raising the Treasury’s costs to issue debt.

Treasury Direct I savings currently paying 1.76%