For long-term financing, governments and firms are able to borrow in the bond market. When investors buy bonds, they are lending money to sellers with the expectation that they will be repaid their principal plus interest. For bond issuers, the bond market provides an efficient means of borrowing large sums of money. For the buyer, bonds provide a relatively secure financial investment that provides interest income.
You are probably familiar with two types of bonds:
Either type makes an attractive investment for people seeking interest income while preserving their principal. The ability to sell bonds on the secondary market makes them relatively liquid, which is also important to investors.
The U.S. government issues several types of bonds with maturities greater than a year. Treasury notes and Treasury bonds are primary sources for financing the federal budget.
The interest rate on the ten-year Treasury note is important because it serves as a benchmark interest rate for both corporate bonds and mortgages. As the interest rate on the ten-year Treasury note fluctuates, corporate rates and mortgage rates fluctuate as well.
In addition to the Treasury, independent agencies of the U.S. government are able to borrow by issuing bonds. Although they lack the guarantee of repayment that Treasury securities have, agency securities are backed by the government and as such are seen as virtually guaranteed. The Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and the Student Loan Marketing Association (Sallie Mae) are well-known agencies that issue bonds in order to finance their operations. Agency securities provide an alternative for investors looking for the security of government bonds but with higher interest rates.
State and local governments are also able to borrow through the bond market. Municipal bonds often finance schools, roads, and other public projects. The interest paid on the municipal bonds is exempt from federal income taxes, which makes them attractive to investors. Because the interest is tax exempt, municipal bonds do not have to offer as high an interest rate to attract investors. As a result, state and local governments are able to borrow more cheaply than the private sector.
Firms are able to borrow in the bond market by issuing corporate bonds. Corporate bonds provide businesses with the money they need for capital investment without having to arrange bank financing. In addition, corporate bonds allow for businesses to obtain funds without diluting ownership in the company. The chief advantage of bonds is that they provide firms with financial leverage. For example, if a company has $1,000 to invest in capital and can expect a return of 10%, the company will earn $100 from the investment. If, however, the firm borrows $1,000,000 and invests in capital that returns 10% a year, the firm is able to earn $100,000 without risking its own money. Because firms lack the ability to tax to repay bonds (and therefore occasionally default on them), investors require a higher interest rate on corporate bonds than on Treasury and municipal bonds to offset the increased risk.
Bonds are not without their downsides. Investors face investment risk, inflation risk, interest rate risk, and the risk of early call (early call means the issuer can recall [“retire”] the bond before the expected maturity date).
Prospective investors rely on rating agencies to determine the quality of the bonds. Moody’s, Standard & Poor’s, and Fitch rate bonds from “prime” to “investment grade” to “junk,” and all the way to “in default.” As a bond’s rating falls, the issuer must reward the investor with a higher interest rate to compensate for the additional risk. The rating agencies provide a useful service and provide much-needed information for the consumer.
However, consumers should not rely only on bond ratings. Serious questions have arisen from the 2008 financial crisis about the rating process. During that time, many bonds were so quickly downgraded that investors who believed they were holding prime-rated bonds discovered that they had junk bonds within a short period of time.
Interest rates are made up of several components: the real rate, expected inflation premium, default risk premium, liquidity premium, and maturity risk. The real rate and the expected inflation premium make up the risk-free rate of return. This risk-free rate of return acts as the benchmark on which all other interest rates are based. Today the various bonds issued by the U.S. Treasury are the proxies for the risk-free rate of return.
Treasury securities have this distinction because the United States has never defaulted on its debt in its 220-plus-year history, and the secondary market for U.S. Treasury securities is considered “deep” because it is backed by the full faith and credit of the United States. The importance of the secondary market in the Treasury cannot be understated. Because so many governments, banks, businesses, and individuals desire U.S. Treasury securities as a risk-free place to park their money, a condition is created where there is no doubt to the liquidity of the securities. The only appreciable risk faced by the holders of Treasury securities is maturity risk. The longer the term of a bond, the greater the chance that interest rates will change from the one that existed at the time of purchase. If interest rates were to unexpectedly rise during the life of the bond, the value of the bond would decrease. As new bond prices fall, the effective interest rate on the bonds increase, which makes previously issued bonds less attractive. This, in turn, makes them less valuable.