In this post “what is a bond?” I’m going to define a bond, the secondary market, and a major way interest rates are determined. If you missed my earlier post on stocks, please click here.
What is a bond?
Borrowing Money=Issuing a bond
People often think a bond is some complicated thing and that misconception is not helped by people who talk about par values and purchasing debt. A bond is simply a loan. When someone purchases a government bond, they are loaning the government money. At some point in the future, the government has to pay you back the principle (the par value) and some interest on top of that. Anyone can issue a bond, which is simply a contract. If you ever borrowed money from a friend and there is some physical or mental record that states you need to pay your friend back then you issued a bond. That is the primary market.
What is the secondary market?
The secondary market is when people purchase other peoples’ loan contracts. Let say Bob lends Frank 100 dollars, and Frank says he will pay Bob 150 dollars in 5 years. That deal is sealed by a contract. Now George offers Bob 105 dollars to buy that contract. So in 5 years Frank will have to pay him 150 dollars. If Bob agrees to the deal that is a secondary transaction. There are multiple reasons that Bob would agree to the deal. Maybe he needs money right away or he thinks Frank is going to refuse to or be unable to repay the loan.
How are interest rates determined?
If the lender thinks someone is a deadbeat, they’ll demand a high interest rate.
The risk of default is the main reason why different bond issuers have different interest rates. If you lend money to the government, it is very likely that they are going to pay you back. That likelihood means that the government doesn’t need to incentivize you with a higher interest rate when they announce the terms of the loan. On the other hand, let’s say we have some guy who launched a company out of his basement. He’s an idiot, he’s losing money, and you think he’ll go out of business in a month. In order for you to be willing to lend money to him, he has to incentivize you with a really high interest rate. An interest rate is simply a way to compensate the lender for taking higher risk.
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Questions for the comments
Did my explanation make sense? Do you agree or disagree with what I said?