What are bonds, treasuries or corporate debt?

In what are bonds, treasuries or corporate debt we look at bonds, bond pricing and how they are affected by expected returns.

A bond is simply a loan. Bonds, treasuries and corporate debt are all loans from savers (who have money), to debtors (who need money) such as governments (treasuries), or companies (corporate debt). Although the loan comes in many types, the loan is usually an interest only loan for the duration, with the principle (in nominal terms) returned at the end of the loan. In normal finance, a borrower borrows money from a lender and pays an interest rate. In bond language, the issuer borrows money from the bond holder and pays interest at the coupon rate.

Little people/companies borrow money from banks who in turn get their funds from the bond market. Big companies or governments bypass the banks and borrow (raise) their money by selling bonds direct to investors. These bonds can then be traded between borrows just as shares are traded on indexes.

Let's say a government is selling $1 billion in 10 year government treasuries (bonds) with a coupon rate of 10%. Investors buy the bonds from the government (buy handing over $1B), and the government agrees to pay the investor 10% of $1B every year ($100M) for 10 years, and then return the original $1B.

Given that bond holder receives his payback over time, we need to understand net present value in order to value the bond. Suppose we consider a government that needs to raise money to give away to taxpayers to prop up a failing economy. Suppose the bonds it intends to sell at 5 year treasuries with a 10% coupon rate and nominal price of $100 billion. The prevailing interest rate is 5%. This means the government will give the bond holder $10 billion every year for 5 years and then return the original $100 billion. Since we know what NPV is we can calculate the current value of that as follows:

• Year 1. $9.52B = $10B/(1+0.05)^1
• Year 2. $9.07B = $10B/(1+0.05)^2
• Year 3. $8.64B = $10B/(1+0.05)^3
• Year 4. $8.23B = $10B/(1+0.05)^4
• Year 5. $7.83B = $10B/(1+0.05)^5
• Year 5. $78.35B = $100B/(1+0.05)^5

So adding up the CV of each element we derive a bond CV of $121.6 billion. We mentioned before that bonds (future cash flows from borrows) can be traded like shares. Suppose 1 day after this bond commenced trading we had an inflation spike (caused by a falling currency and rising commodities prices) and the bond interest rate went up to 8%. Sparing you the maths (just replace '0.05' above with '0.08') the current price of the now 1 day old bond is...

$108.0 billion. The original owner of this bond just lost $13.66B or 11%. If you haven't worked it out yet, bonds are really important and you can make or lose a lot of money. In 'How are bonds and inflation related?' we look in more detail at the importance of bonds in the economy. In 'How much money did Asia and the middle-East just lose?' we look at global bond trading.