Bonds (and Bad Breath)

Illustration by Konani Chinn

Bonds are debt: IOUs issued by corporations and governments. They can be traded like stocks, and their value is constantly changing based on their interest rate and chances of getting paid back.

Story: Bad Breath City

Say you borrow $200 from a friend to buy a bike. You write out a note which says: I’ll pay you back two years from now, and in the meantime will pay 10% interest per year. You give the note to your friend, and the friend gives you $200 in cash.

You’ve basically just issued a bond.

Now imagine a mythical city named Bad Breath City. They discover there’s a problem with their water supply that’s causing everyone who drinks their water to have bad breath. Fixing it will cost $200 million dollars (it’s a big city).

The Bad Breath city council decides to ‘float’ a thirty-year bond for $200 million to raise the capital to fix the water system. The bond will be paid back, with 5% interest, over thirty years. And it will be ‘secured’ by revenues from the city water utility. This means that if the city fails to make their payments, the holders of the bond can sue to take the water bill revenue directly from the city.

So now we have two bonds: the bike bond and the bad breath bond. Both can ‘trade’ on the bond market (be resold by the original holders to other investors). Which one will investors like better?

The bike bond pays a higher interest rate (10% vs 5%) but it’s unsecured (you didn’t promise the bike as collateral if you failed to pay back the loan).

On the other hand, Bad Breath City may not be a very good credit risk, and $200 million is a lot to borrow. And because so many of its residents have bad breath, people have been moving away and the population is shrinking.

Investors are constantly changing their opinions on the value of bonds, and the market prices (what those bonds trade for) reflect those opinions. Someone might offer $100 for the $200 bike bond, for example, because they think the chances of it getting paid back are only 50/50.

Over $120 trillion of bonds have been issued worldwide by governments and corporations. The U.S. government is the world’s biggest bond issuer, with about $25 Trillion outstanding (thats a big IOU). The biggest corporate issuers are companies you’ve heard of, like AT&T, Ford, Verizon and Comcast, who have over $100 Billion in bond debt outstanding each.

For several years, interest rates have been very low (close to zero) so it’s been easy to issue big bonds cheaply. Whether those debts get paid back – and whether the investors who bought them end up happy – is another question.