Bonds – A Primer (part 2)

Part 2 – Fixed Income History and Overview

In the previous post in this series we introduced the fixed income market and compared it to the equity market. In this post, we will delve into the history of fixed income and discover how modern day fixed income markets came to be. Then, we will give an overview of the basic mechanics and terminology of bonds and other fixed income instruments

The History of Fixed Income

The first recognized bond was discovered in 1889 in Mesopotamia, which is modern day Iraq. The agreement, a contract between two parties for the delivery of grains, was inscribed on a stone tablet circa 2400 B.C. The grain producer signed off on a specific delivery of product to the second party. If the grain producer did not deliver the grains the purchaser was to be reimbursed for what they had already paid. The agreement was witnessed by four individuals, and the seed of a bond was planted.

The next iteration of a bond happened in Venice Italy circa 1100 A.D. At that time Venice was a focal point of the world. It was a center of art, education, progress, and trade. Venetian merchants were stationed and traveling around the world, and this made them a target for enemies of Venice. Constantinople, in particular, was a parallel power to Venice and they made a bold decision to imprison and confiscate Venetian merchants and property. Venice was not going to take this and decided to retaliate.

The Venetian government had a problem. They needed proper equipment to mount an offensive. They did not have adequate shipping capability and needed to produce ships quickly.  Ship building costs money, which they did not have, so their solution was to levy a tax on the citizens. This tax included a provision which stated that the Venetian government would repay the citizens when it was able to. During this time the religious climate had made loans essentially illegal, so this was pushing the societal boundaries.

Unfortunately for the government, there was another big problem at the same time. The plague was running rampant across the fleet, depleting their numbers. The offensive failed and the fleet came back home to a government unable to repay the citizens. This inability to repay the citizens caused great instability. In an attempt to pacify their angry constituents, the government promised to pay back the citizens an additional percentage of their loans each year until they were made whole. Hello, interest payments!

This new type of government loan with periodic repayment was called prestiti. The prestiti allowed Venice to finance government sponsored projects without having the capital.  Previously they would levy taxes to get the funds with no benefit to the citizens. This new form of borrowing was a benefit to both sides. The government could fund projects, and the citizens could earn periodic payments in return.The citizens of Venice loved these so much that they even started buying and selling them between each other.

And thus, the bond market was born.

As good ideas tend to do. the prestiti spread and evolved. Governments began to use this new form of financing for civic, economic, and military endeavours. Indeed, many of the world’s wars have been funded from bonds since their creation. Businesses were quick to adopt this approach as well. The Dutch East India Company  (VOC) issued bonds for funding in the early 1600s. Many consider this to be the genesis of the business model of what we call publicly traded companies today.

For more on the history of fixed income and currency in general, David Graeber’s Debt – The First 5,000 Years is a fascinating read.

Bonds – The Basics

A bond is essentially a legal contract between parties. Each contract has similar components and in the following sections we will outline the main components of a bond.

Issuer

The issuer is the entity that is looking to raise capital, and there are 2 primary issuers:

  1. Governments – US Treasury, Foreign Governments, State & Local governments. Additionally, there are bonds that are issued by government related entities (Fannie Mae and Freddie Mac in the US)
  2. Corporations – By issuing bonds, corporations can oftentimes get better financing terms than from their bank because there are many more potential buyers to drive down the price.

*Look out for more detailed posts on Government Bonds & Corporate Bonds in Part 3 & 4 of this series!

Coupon (or Coupon Rate)

The coupon is the interest rate the issuer is willing to pay to bond holders. The coupon rate is determined primarily by the issuer’s credit quality and how much time there is until the maturity date. It is expressed as a percentage value.

Example:  5% annual coupon on a $1,000 value investment = $50 per year

Payment Frequency

The payment frequency denotes how often the issuer will pay a coupon to the bond holder. The most common frequencies are monthly, semi-annual and annual.

The payment frequency is an important attribute because it affords the flexibility to create a consistent payment flow.  We will talk more about this later.

Maturity Date

All good things must come to an end. The maturity date is when the bond issuer will make the final interest payment and return your principal investment. Once the maturity date has been reached the contract has been completed and the bond will be retired.

Price

Most bonds are sold at a price of $100.00 (or par) when first for sale to the market. Once the initial sale has been completed, bonds can be traded in the secondary markets. This means you can potentially see price appreciation on the bonds you purchase. The other side is you can lose a portion of the principal you invest if you need the money and are forced to sell at a lower price than you paid.

At InterPrime, we are not inclined to actively trade bonds for price appreciation. We are more interested in holding to maturity and receiving consistent, periodic payments.

Bonds – Key Considerations

Interest Rate & Duration Risk 

One of the most important things to understand about bonds is how their prices react to changes in interest rates. Bond prices move opposite to the direction of interest rates. Interest rate policy in the United States is set by the Federal Reserve and is adjusted depending on the economic conditions. 

Duration is also a key component of a bond’s price, and it is a measure of the sensitivity of the bond’s price to a change in interest rates. i.e The longer the maturity and the higher the coupon on the bond, the greater the duration & therefore the greater the impact of interest rate changes on it’s price.

Liquidity Risk

While electronic trading systems have made the bond market more liquid, certain bonds do not trade as actively as others. If you happen to purchase a bond that is not actively traded, you risk getting a sub-optimal sale price if you want/need to sell.

Creditor Status

When you purchase a bond, you are in essence making a loan to the issuer (creditor) of the bond. Hence it’s critical to know their creditworthiness. If it’s the U.S. Government, you can rest assured that they will pay you back, but if it’s a corporation, then you need to be a bit more careful.

Payment & Maturity Matching

With so many different issuers and maturity dates, you can almost always find a bond that matches your investment timeline.

If you want to park your money for only two quarters, there should be a selection that matures in two quarters. What about 2 years from now? Yep, those are out there too.

What about if you are looking to offset a particular expense you have to pay? With a little more research and due diligence you should be able to find a bond to match most or all of your expense’s cost.

Wrapping up

Investing in stocks gets all the excitement and media coverage but bonds should not be ignored. Bonds are able to give you a consistent and predetermined income payment with some protection if the bond issuer has financial troubles. These characteristics are usually not possible when investing in stocks.

In upcoming posts, we will dive into specific types of bonds. In the meantime, if you have any questions reach out to us at InterPrime. We are always happy to discuss different types of assets and their uses in corporate cash management.

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