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” some. That will force our interest rates up, regardless of what the Federal Reserve does.
How exactly does this all work? Most people understand that a bond involves some institution, typically a government 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 government 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 $1,000 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 actually 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 market. After that, most 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 4, 6, 8, 13, 17, 26, and 52 weeks are “bills.” These are like the Series E or EE savings bonds that could be bought for about $18, but for which one received $25 some 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 2, 3, 5, 7, or 10 years. Interest is paid every six months to whomever owns the note as of a specific date.
Currently, Treasury Bonds per se are sold only for 20- and 30-year maturities. Interest is paid twice a year. Regardless of the “bill” versus “note” versus “bond” technicalities, all debt of the U.S. government 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 most favorable interest rate for that particular auction. (Read “About Treasury Marketable Securities” at treasurydirect.gov for an excellent explanation of this.)
Once any Treasury security 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 market,” 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 some 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 potential 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 risk of default, contracts for deed suited the circumstances of some sellers and some buyers.
One reason was that it was a solution for lack of liquidity. If you had sold a property on a contract for deed but your situation then changed so you needed cash immediately, 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 $150,000 principal remained to be paid, you might get $120,000 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 1972 with 7.5% interest due every year on the outstanding balance. Then, in 1977 with $80,000 still owing, interest rates had risen to 9%. You only would find a buyer for that CD if you took a real haircut. No one would give you $80,000. Depending on the number of years left, you might get $65,000 or less.
The “or less” depended on this differential between the interest rate in the contract compared to current rates. Possible 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 ways. “Seasoned” bonds that were issued a few or many years ago can be readily bought and readily sold. Ones issued by different entities, Xcel Energy, Roseville Public Schools, the U.S. Treasury or the Republica Argentina each have different levels of risk. However, rating agencies such as Moodys, Standard and Poors or Fitch track all relevant variables closely and assign ratings tied to the level of risk. 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 needs cash and come back to this space next week for a further explanation.
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St. Paul economist and writer Edward Lotterman can be reached at stpaul@edlotterman.com.
