CM.bond1

Many of you own a savings bond so you already have some experience with the class of assets known as bonds. In this section we are going to look more closely at bonds and answer briefly the following questions:

Although there is an enormous range in the type of bonds issued, in general you can think of Bonds as IOU's - a promise to pay a certain sum of money in the future. For example, you could buy a promise to pay you $1000 at the end of year 1 and 2 and $11,000 in three years.

Bonds are issued by companies, governments, or government agencies to raise money to pay its bills or to finance some capital investment. When your home town needs money to build a new school or the state needs money to build a new prison or 'bribe' a company to move its operations to the state, they will issue a bond. By issuing the bonds, the state or local governments are able to spread out the payments for the buildings and the bribes over a longer time horizon. When the federal government runs a budget deficit, it is paying out more money than it is taking in in taxes and it must sell bonds to meet the expenses not covered by tax revenues. You may have seen the posters of Uncle Sam during W.W.II urging Americans to buy bonds to help finance the war. Americans would give the government money which it would use to build boats, planes, tanks... and the government would give people government bonds. An example of these bonds would be the US Savings bonds which you may have received as a gift at some point in your childhood. Finally, in 1998 the dorms were wired for computers and the money came from bonds issued by the State of Rhode Island. Investors gave the State money and the State gave them a bond (an IOU) that guaranteed to pay the holder of the bond a specified amount of money in the future. This is the same principle behind your taking out a car loan to buy a car or a home mortgage to buy a house.

The reason you would hold bonds is the same reason you would hold any asset - to make money. Essentially what you are doing is giving up your money today and being paid back more in the future. You can make money two ways. The first is simply hold onto the bond and collect the scheduled payments. Returning to the opening example, you would hold on to the bond and collect $1000 at the end of year 1 and 2 and $11,000 in three years. But there is another way to make money - and to lose it. You could make additional money if the bond increased in value. In this sense it is just like owning a house, stock, antiques, and art that appreciate in value. In our opening example, it would be possible that you paid $10,000 for the future stream of earnings - $1000 at the end of year 1 and 2 and $11,000 in three years - but now you find its price has risen to $11,000 or fallen to $9,000. To understand the changes in the price of bonds, we need to look at the link between the price of the bond and interest rates.

Because bonds are a promise of a borrower to pay money in the future in return for a lender's money today, we need a way to compare today's money with money in the future. This is not all that simple, but you understand the essence of the problem because none of you would trade $100 today for $100 a year from now. There is a sum of money you would accept - it just wouldn't be $100. Maybe some would take $105, while others would hold out for $110. In each case, however, the link between the current price and the future payments is the rate of return and the method that we use to calculate the link is present value analysis.

To demonstrate the essentials of the analysis, we will examine two simple examples. The first will be a bond that you are most likely to be familiar with, the US Savings Bond. In fact, many of you may have some $25 bonds which were gifts at important times in your life. The reason this bond is such a great gift (for the giver) is the bond says it is worth $25 dollars, but in truth the person who gave it to you paid much less than $25, and you will not be able to get the $25 until sometime in the future. The question we will look into is: What is the price of the $25 bond, and you will not be surprised that the answer depends on the interest rate.

For a more realistic example, we will look at a three year, $1,000 bond at an interest rate of 10%. You would give the government your $1,000 today and it would pay you the $100 (10% interest) at the end of this year and the next two years. At the end of the last year it would also give you back the initial $1,000. In other words, you would be paying $1,000 to receive $100, $100, and $1,100 at the end of the next three years. The question to you is: Why is the price of this bond equal to $1,000? Again the answer depends on the interest rate - how fast money will be growing. We will examine both of these examples in the section on Bond Prices and Interest Rates.

Is a bond a safe investment? This is a reasonable question when one is considering an investment, and with bonds there are two components of risk. The first has to do with the ability of the borrower to pay back - what we will call default risk. In 1998 the world's financial markets were thrown into turmoil when the Russian government announced that it would not be making the scheduled payments on its debt. For those who remember the early 1980s, this was just a rerun of the debt crisis that arose when a number of Latin American countries announced that they would be unable to pay bond holders their money. When it comes to companies, all companies are not the same when it comes to risk, and as we will see a bit later, the differences in risk are reflected in differences in the cost of borrowing. On the one end we have the large, established companies such as GM, GE, and IBM that can borrow at relatively low rates while at the other we may have MG, EG, and MBI - small start-up companies with no established track record who will pay dearly for money.

The second source of risk is the price of the bond. You could lose on your investment if the price of the bond that you own decreased in value. Because as we saw earlier the price of the bond is closely related to interest rates, losses or gains in the value of a bond can be traced to changes in interest rates. We will examine both of these examples in the section, How safe are bonds?

Information on the price of bonds can be found in the Wall Street Journal in the same section as the stock market information. A copy of the New York Exchange Bonds provides information on the price, time to maturity, and return (yield) on bonds. For example, Duke Power bonds that will mature in 2002 and had an initial coupon rate of 73/8 and initially sold at $100 is now selling at $875/8 (Close), unchanged from the previous day (Net Chg.) when $8,000 of bonds were traded (Vol). The rate of return on this bond would be 8.4% (Cur Yld). If you are interested in some key indexes of bond prices as well as information on some tax exempt bonds and international bonds you can find Bond Market Data Bank in the Wall Street Journal.

If you are interested in US government bonds, then you would look for the table Treasury Bonds, Notes & Bills which provides basically the same information. You will find something that looks similar to the table below in the WSJ.

Maturity
Rate	Mo/Yr	Bid	Asked	Chg	Ask Yld.
5 3/4	Oct 02n	100.15	100.17	-2	5.61