How it works.

An excellent article on the bond markets and why Ireland has a very good chance of becoming bankrupt.

Thu, 11 Nov 2010 10:06:04 -0500

An excellent article on the bond markets and why Ireland has a very good chance of becoming bankrupt.

The Price and Yield of a Bond

Sun, 07 Nov 2010 17:19:02 -0500

So far the discussion around bonds has only skirted around the issue of price through talking about coupon payments. In order to understand the risks of staying in debt and refinancing, and what it means for people to talk of the “tyranny of the bond market,” more must be brought to light.

The “yield” on any investment is best thought of as the percentage return that the investor will get back at the end of the investment. In the case of a bank giving out a loan to someone to buy a house, the yield is the interest rate that is paid back by the homeowner. A bond is just like a loan where the company or government selling the bond is promising to pay back the amount plus the coupon payments (interest payments), which constitute the yield. Say a car company wants to build a new advanced plant to make engines and so to raise the funds it issues hundreds of millions of dollars in bonds. These bonds will all have a yield in the form of guaranteed coupon payments. To somewhat simplify: if the bonds are issued with a notional of $10,000 and the coupon payments are paid yearly at $500 then the yield is 5% since over time the investment will return 5% on a yearly basis.

The entire reason why money is lent in the first place is because the person or company making the loan likes the yield that will be returned to them. With higher yields comes higher returns to the investor and so with all things considered equal they would rather lend out their money to an investment that had a higher yield.

The price of a bond is simply the amount that it costs to purchase the contract. In the case of the car company above the price is $10,000 at the start of the contract if people are willing to purchase it for that amount. If everyone simply purchased bonds when they were initially issued and put them away in their safety deposit box to receive coupons and eventually notional payments at maturity then that would be the whole pricing story. However, much of the debt (bonds) of the world is instead held by groups that look to buy and sell them during their lifetime on the back of changing prices. It is how these prices change over time that we’ll look at in the next post.

Recap

Mon, 01 Nov 2010 22:15:41 -0400

Bond – A contract to pay back an amount of money at some future date. This normally includes a smaller payment on a periodic basis (yearly, monthly, etc…)
Notional – The amount of money that will be paid on the bond at the future date.
Maturity Date – The future date when the bond will pay the notional.
Coupon – The smaller payments made on a periodic basis.
“Rolling Over Debt” – Selling a new set of bonds to pay the notional on the old bonds that are maturing. In this way the company or government can stay in debt forever.

(When I started this blog I wasn’t able to foresee the amount of work that was about to come at me in my regular job and hence the “weekly” posts have fallen into quarterly. I won’t promise how regular I’ll be in the future but with the first snow yesterday and the weather cooling quickly maybe I can come at this with a bit more vigor.)

3. Staying In Debt Forever

Thu, 17 Jun 2010 22:00:22 -0400

Being in debt is the normal way of living for most Canadians where the vast majority of the population does not have enough money on hand o pay for a university education, a car, or a house. Instead loans and mortgages are taken out from banks, governments, or other financial institutions and gradually paid back, with interest, over a certain length of time. The goal for most is to get out of this debt by paying back the interest plus some part of the principal every month so that slowly the level reduces until finally at some point later in life the education, car, or house is owned outright.

Companies and governments are not like this- instead they can, and many do, live in debt forever. Companies that have financed their investments and operations through the selling of bonds at some point find themselves needing to pay back the notional. The term “rolling over the debt” explains how a company can sell a new set of bonds and use the funds from this sale to pay off the old bondholders. In effect the company has changed their debt from the previous set of bonds to a new set that will themselves mature at some point in the future. By continuously doing this, a company is able to keep its debt and not interfere with normal operations.

For example: A paper company has $50 million in bond notional that is maturing in a month and it needs to find the money to pay at this due date. By selling another set of bonds that mature in five years for $50 million the company can pay off the initial bondholders and have obligations to a new set. It has successfully “rolled over” its debt to the new set of bond. In five years the same procedure is repeated and this process extends for as long as the company wants.

Governments are no different and one of the many tasks that a central bank is normally tasked with is the refinancing or rolling over of the existing debt.

This may all sound like companies and governments are able to get a free lunch, that they can simply live on their debts forever without any repercussions. That is because I have not talked about a very important part of the bond selling process, the price that people are willing to pay and the coupon payments that must be made. These last points are exactly what the crisis in Greece has been about and next time I’ll discuss the perils of debt rolling and what happens when things go wrong.

Twitter Account

Thu, 20 May 2010 21:39:17 -0400

I started up a twitter account for this blog. It will mostly be used at first to announce when new posts are up, although I may also post additional links and quick thoughts in the future. http://www.twitter.com/howworks

2. Government Debt

Thu, 20 May 2010 21:29:40 -0400

In Canada every year the different levels of government produce budgets that will outline how resources will be used and collected in the following twelve months. Estimates of the costs of different programs will be listed as well as the sources of revenue that will flow into government coffers be it income or sales taxes, corporate taxes, or profits from crown corporations. At the end there will be a final tally showing either a surplus (the sources of revenue are greater than the expenses) or a deficit. (the government will spend more then it takes in) How does the government get the money to function when it runs a deficit? It sells bonds.

Just like the company in the previous entry that needs money a government will sell bonds to raise the needed funds to pay for the programs that it doesn’t have the money for. For example, when a budget is released that says that the government will run a $2 billion deficit in the next fiscal year that means that at various times it will have to sell bonds that will total the shortage. These bonds will be the same type as any other with dates of maturity when the notional must be paid back and a set interest payment (a coupon) that will be made on a predefined frequency. Because governments have entire countries backing them they are able to issue bonds that have maturity dates up to 30 years into the future.

These bonds are what actually makes up the government debt and so another term frequently used is “government debt” when talking about the bonds. So who buys this government debt? Pension funds and life insurance companies buy much of the debt as they need to plan generations into the future and prefer to have stable coupons and returns on investments that in many ways only government bonds, with very long term dates of maturity (30 years or more), can provide. Other large buyers are mutual funds, investment dealers, chartered banks, and other governments. Government debt is also held by its own citizens, in Canada these are in the form of Canadian Savings Bonds. When you go out and buy a savings bond you are actually helping the government of Canada finance its deficit.

This all brings on the question of what happens when bonds mature and governments or companies still need the money or simply can’t pay and it leads into the next topic of refinancing.

1. What is a Bond?

Thu, 13 May 2010 22:46:00 -0400

One only needs to look into the news to understand the importance of bonds in today’s world. The protests in the streets of Athens are essentially all about bonds, bondholders, and the government’s ability to sell more bonds. So, what is a bond?

At its most basic, a bond is a contract that is sold with a promise to pay a certain amount of money back at some point in the future. Many bonds stipulate an interest payment, or in bond terms a “coupon,” that must be made on a regular basis to the owner of the bond until the final year when the “notional” is paid out. This final year is known as the bond’s maturity. A bond is much like a loan where the seller or issuer is the borrower and the purchaser or holder is the creditor.

Imagine that there is a company that decides to sell a bond with a notional of $10,000 that will mature in 10 years and will pay a 5% coupon every year. The purchaser of this bond will receive $500 from the company each year for the first 9 years and then on the 10th and final year the bond matures and the company pays out the $500 coupon plus the $10,000 bond notional. The company may do this if it needs money to fund its operations, provide a cash flow before sales pick up, investment in a new factory, or further research and development. Just like a loan it now has the money that it needs along with the obligation to eventually pay it back. A major difference with what is normally thought of as a loan is that there is no slow repay of debt, here it is all paid back at once at the end with only the intermittent coupon payments in between.

Next we’ll look at how governments use bonds.

If the world runs on Finance then this is how the world runs

Sat, 01 May 2010 16:37:00 -0400

I’ve always felt that it is important for people to explain in understandable language what it is that they know so that others can learn from them. For scientists, this is the ability to take vastly complex subjects and find the language that will allow everyone else to understand essentially what the issues are. The magazine Nature has articles with pure science as their main focus but spend the first part of each issue discussing in less complicated terms what these documents actually mean as well as their possible repercussions.

This is fine for the hard sciences; physics, chemistry, biology, climatology, etc.. but in the social sciences it is more about helping people find their way through a confusing array of terms. Chomsky has written extensively about how different disciplines will build a wall of terminology in order to keep others out unless they pass through the mountain of education needed to enter their spheres. While vastly oversimplified I believe that there is great truth in this idea and that it is on the shoulders of those who understand to share with others.

I wouldn’t try to suggest that finance is even a “soft” science but it is full of terms and ideas that while vastly important to everyone on earth are really not understood by most people. My goal on this blog is to post about once a week talking about very basic ideas in ways that everyone can understand. I will be writing mostly about finance but also some economics or anything else that seems to be pertinent to the theme that I feel important. I’m not an expert, but I’ve been working and reading and studying long enough now to know a bit how things work. I can’t remember the exact reference, but someone once told Pascal (unless it was he who told someone) that if you wait to read all about a subject before venturing to tackle a problem in it you’ll die before creating anything. So with that, lets begin…