Stocks and Bonds: Risks and Returns

Who are the borrowers in bond markets? Here are some statistics. The US
Treasury is the largest, with around $11 trillion of outstanding Treasury
bonds, as of the end of 2012. A Treasury bond is an IOU from the Federal
Government, it is a security entitling the holder to specified payments
from the US Treasury.
Next are U.S corporations with around $8.5 trillion of traded bonds
outstanding. Then there's a large dollar amount of bonds related to home
mortgages around 8.2 trillion. If you buy a home and take out a mortgage,
you must make periodic payments to the bank to pay off that obligation.
So, in fact, when you take out the mortgage you are selling a bond to the
bank. The bank holds on to some of these individual bonds, until they
mature and the loan is paid off. But other mortgages are packaged together
into mortgage backed securities and sold to investors.
The last category I'll mention are municipal bonds. These are bonds issued
by state and local governments. There're about $3.7 trillion of these bonds
outstanding. Combining these top four with several other categories, U.S.
borrowers have issued $37.7 trillion of bonds. That compares to annual U.S.
GDP of around 15.7 trillion.
GDP is the value, the total value, of all goods and services produced in
the economy. So the bond market is around 2.4 times our GDP. Do these
statistics on the bond market represent all debts outstanding the U.S
borrowers owe to creditors? Definitely not. First of all, when I was
talking about mortgages, I mentioned that some are sold to investors but
others are not.
Those that are not, remain on the balance sheet of the bank as loans.
Banks, credit card companies and the financing arms of many other
companies, also provide large amounts of business and consumer credit. This
credit is to finance the purchase of consumer goods, capital goods or
general spending.
Second, the federal government collects contributions from your paycheck
for Social Security and Medicare, called Payroll taxes. In exchange they
have pledged to provide an annuitized stream of income for you or health
insurance benefits when you retire. Those are also dead arrangements as
well. Where you have given money to the Government through payroll taxes
and the Government has pledged to pay you an annuity when you retire.
Similarly, State and Local Governments and some firms have also promised
payments to retirees through defined benefit pension arrangements and
promises for retiree health insurance. These are not technically bonds, but
Social Security, pensions, and Medicare are a large category of government
debt. And, just like if we were analyzing a bond or another type of debt,
we'll have to consider whether there's a risk of partial default on these
obligations.
Finally, an annuity, the promise an insurance company has made to pay
people streams of payments for the rest of their lives. Is also a kind of
private bond. The purchaser gave the insurance company cash when he or she
retired and the insurance company now owes the individual a stream of
payments.

So these other categories of debt, which we typically call loans

pensions instead of bonds, are really just like bonds other than
that they are not quite as readily tradeable. But the difference
great as you might think. Banks actually can syndicate loans and
them for investors.

and
the fact
is not as
repackage

Insurance companies trade bond-like securities that provide many different

types of streams of income. And as long as we know what the promised stream
of payments looks like and what the risk profile is of those payments, we
can price these promises as though they were bonds and get a sense of how
much that promise is worth.
Coupon bonds.
Let's consider traditional bonds. A bond promises to repay an amount upon
maturity. Maturity means the end of the life of the loan. The promised
repayment amount is called the face value, or par value. Most commonly, the
bond also promises to pay the holder periodic interest payments, which are
specified as a percentage of the face value.
These payments are called coupons or coupon payments. A bond that promises
to pay periodic interest payments plus repayment of principal is called a
coupon bond, or par bond. Let's see how this generally works for U.S.
Treasury bonds. The Wall Street Journal website provides regular
information about the yields on recently issued U.S. Treasury bonds that
mature at different dates.
Here are some numbers from their screen on March 6th, 2013. Each row of
their table represents one bond issue with a different maturity date. So,
let's consider the line for a bond that matures on February 15th, 2023.
Given that these are recently issued bonds, I can tell you that this bond
was issued on February 15th, 2013 with a maturity of ten years.
These bonds typically have a face value of $1,000. This one has a coupon of
2%, which means that the annual payments the bond makes will be $20 per
year. But actually, since U.S Treasury bonds pay interest semi-annually,
that means twice-per-year, the holder gets $10 every six months. Here is
the timeline of scheduled cash payments for this bond.
On the issue date, the buyer pays some money to the government. Then every
six months, the buyer gets a coupon payment of $10. That continues until
the day of the 20th coupon payment ten years from now, when he gets that
last $10 coupon payment plus $1000. Remember that the 2% rate, which
implies these $10 coupons twice a year, as well as the $1000 at the end, is
written into the Treasury Bond contract.
These things are for all practical purposes written in stone. They cannot
be changed. The buyer of a Treasury bond always knows what she is getting,
at least in nominal dollars, though not purchasing power. And of course,
assuming that the U.S. federal government does not become as financially
distressed as Argentina or Greece, these are the closest thing we have to
non defaulting nominal promises.
What actually happened at the auction when the bond was sold? You can find
out on the U.S Treasury direct website that it sold for $99.5859 per
hundred dollars of face value, which is around $995.86 per $1,000 of face
value. That means that bond buyers on February 15th were a little less
enthusiastic than the government thought they would be when the government
set the coupon rate.

So, what have we learned about coupon bonds? These are the most standard
types of bonds. We took an example of a Treasury bond issued by the U.S.
government and looked at its price at issuance, and several weeks after it
was issued. At the time of issue, investors discounted the future payments
a little more than the Treasury department expected, paying a little less
for the bond than the $1,000 face value.