Bonds in the United States of America

Introduction

Bonds refer to a form of arrears where private and public systems seek financial aid from institutions or individuals to sponsor various projects. The debt is payable at a variable or a predetermined interest rate within a specified timeframe. In nonprofessional terms, a bond is a form of an advance where individuals or institutions serve as the lending bodies that give a government, a corporation, or a municipality a loan where such institutions promise to recompense in full with regular interest payments (Pento, 2013). The issuer of the bond becomes the creditor while the one who receives the loan is the debt holder. Bonds are also classified as fixed-earnings securities, which form one of the standard property categories that include supplies (equities) and currency equivalents. Corporate and government organizations trade their bonds publicly while others vend them over-the-counter (OTC) (Brown, 2006).

Bonds have several features, which are important to have a deeper understanding of this generic asset. Firstly, the principal refers to the amount that a teller has given out to the borrowers. It denotes the amount upon which the debt holder pays interest as guided by the agreement at the issuance point of the bond. The second important term is maturity, which refers to the date at which the debtor has to settle the borrowed amount to the creditor (Pento, 2013). The United State Treasury Securities has three categories of bonds, which include the short-range category where the maturity period goes up to half a decade, the medium-term category that is repayable for a maximum of 144 months, and the long-term type where the maturity period is more than 12 years (Brown, 2006). The third term is the coupon, which refers to the interest fees that the lender disburses to the liability proprietor. The interest charges are often unchangeable throughout the lifetime of the bond, although they also vary with the money market index (Pento, 2013). Coupons are paid at different intervals and frequencies such as semi-annually or once a year (Pento, 2013). The other important term is credit eminence, which refers to the acknowledgment rating of the lender. Credit merit is an important aspect for consideration when loaning money to the issuer (Choudhry, 2006). If the issuer’s credit aptitude is pitiable, the risk is higher for creditors. Hence, such situations attract a higher interest fee as compared to the case of an issuer who has an excellent credit rating.

Securities markets have taken centuries to develop. The concept of debt is traceable to the ancient worlds such as Mesopotamia where evidence relating to interest-bearing loans has been found on clay tablets (Brown, 2006). However, the history of bonds can be traced back to the Republic of Venice, which is now part of Greece. In 1171, concerns relating to the war in Greece depleted the treasury segment’s resources to the extent of leading the government to draw a forced loan from the citizens. The loan, namely the prestige, which was paid at an interest rate of 5% per annum, had an indistinct maturity period (Choudhry, 2006). Although the citizens initially viewed such loans apprehensively, the situation turned to a viable form of valuable investment that they could trade, i.e. purchase and advertising. Thus, the bond bazaar came into existence (Brown, 2006).

In the United States, the history of bonds is traceable to the 20th century starting from 1900 when the country’s securities market was rapidly growing at a time of economic boom. The events of World War I and II were a major factor that drove the US Treasury to issue bonds to help the wars (Faerber, 2001). During World War I, war efforts were financed through the increased taxation and sale of war bonds, which financial institutions referred to as the “Liberty Bonds”. They allowed individuals to purchase these bonds, which were payable at the end of the war at an unchanging rate (Choudhry, 2010). The events of the war were very expensive for the US. Further, the great depression of the 1930s aggravated the matter even more. The recession affected the US’s ability to disburse its initial creditors. In this case, the US had to issue new bonds to forfeit the existing one, hence rolling over the preliminary arrears into bills (Choudhry, 2006). As the US got more involved in war activities throughout the world among other activities and dynamics such as inflation and labor wage increments, the country’s debt rose drastically as the demand for financing augmented radically (Brown, 2006). The state sought aid from outside its borders. Foreign governments slowly became holders of the United States’ debt. Now, the US Treasury Bond market is the world’s largest bazaar and one of the safest and trusted souks (Choudhry, 2010). The treasury section issues the treasuries since the federal government, which has the full backing of the US government, makes bonds the most popular and safest investment in this securities market segment.

Types of Bonds

Several types of bonds are currently available in the bonds market. Concerning the American securities market, this section provides an in-depth discussion of the various bonds that are traded on the market.

The US Treasury Securities

The American asset securities include invoices and bonds that reveal the arrears of the American administration. The American bonds are availed to the market through the Treasury Department where they (bonds) are availed to investors as publicly traded or over-the-counter bonds (Pento, 2013). When shareholders purchase an American Treasury bond, they give the funds to the centralized government where such investment is payable after a particular time. The US Treasury Security bonds act as debts on the federal government. High credit merit is deployed as a backup of the federal government due to its ability to raise tax revenues and/or print currency. Many people viewed it as almost risk-free. These high levels of security make the US Treasury Securities the safest investment that an investor can make (Brown, 2006).

However, as previously mentioned, the credit value of an issuer is a crucial determiner of the interest rates that an investor may charge for buying the bonds. In this case, issuers with low credit ratings indicate a higher risk for investors since the likelihood of default is high and hence the need for the elevated interest charges (Pento, 2013). Contrary to this case, the US Treasury Securities body is highly secure such that investors are guaranteed of getting their money back. This observation means that they attract a very low-interest rate.

The US Treasure Securities is the world’s largest bond corporation. As of 2010, it had USD$8.85 trillion in outstanding bills and bonds while its trading capacity averaged USD$ 949.8 billion a day during the same time (Pento, 2013). It is also the world’s most liquid debt bazaar. Hence, its pricing, execution, and settling of trade and transactions are quite resourceful and reasonably priced. The US Treasury Securities’ bonds are sold throughout the day where the US primary dealers do continuous and live marketing of these bonds both within and outside the country in other major securities markets such as London and Tokyo among other securities across the world. In 2010, the US Federal Reserve estimated that of the US Treasury Securities, individuals, banks and mutual funds, public and private pension funds, foreign investors, state and local governments, and other investors held 10.2%, 11.7%, 6.6%, 47.7%, 6.8%, and 16.9% respectively (Pento, 2013).

The US Treasury Market and Inflation-Protected Securities

The US Treasury Market and Inflation-Protected Securities are special security that is often referred to as the Treasury Inflation-Protected Security (TIPS) where the principal amount is adjusted for inflation during the duration of the security (Choudhry, 2006). The main reason for the issuance of the TIPS is that the financing body supposes that such supplies will not only cut the interest charges to the government in the end but also act as an incentive for diverse classes of shareholders to procure their liability tools.

Agency Bonds

Agency bonds refer to debt obligations that are issued by two types of entities, namely the Government-Sponsored Enterprises (GSEs) and the Federal Government Agencies. GSEs refer to federally chartered but privately owned corporations (Pento, 2013). The two entities often issue or guarantee bonds to finance activities and projects that are of public importance such as increasing homeownership financing or providing agricultural assistance among other pubic-related activities. Agency bonds have various conditions, structures, maturities, and coupon charges.

Each GSE or Federal Government Agency steers the issuance of the agency where each entity is in charge of determining and issuing its bonds. Terms and sizes are determined based on the need and purpose that such financing is set to serve. Organizational bonds are regularly set at the least amount of USD$10,000 for the initial savings that are followed by a subsequent augmentation value of at least $5,000. However, some agencies require higher amounts of initial investment such as the Ginnie Mae Federal Agency bonds, which require an investment of at least $25,000 (Pento, 2013). The intensity of default risk of a bond issuer is often a factor that defines the level of independence in the government where agencies that have close links to the governments are considered to have negligible default risk as compared to those that lack close ties to the government (Choudhry, 2006). However, most, but not all, interest rates from these agencies are exempt from taxation. This exemption makes them lucrative for investors.

Some of the bureau securities that are availed by GSEs include the accommodation segment bonds that are provided by the National Housing Credit Advance Association, and the National Housing Finance Depository. For the agricultural segment, the Centralized Farming Advance Conglomerate, Agriculture Advance Scheme Monetary Aid Business, and the National Advance Stores issue bonds. Contrary to the American treasury Supplies, GSEs are not supported by the complete assurance and acknowledgment of the American administration. Hence, since they are viewed as having more credit risk, they attract a higher interest rate (Pento, 2013). They give higher yields than the US Treasury Bonds.

The Federal Government Bureaus issue agency bonds. Such securities comprise the supplies that are offered by bodies such as the Undersized Commerce Government, the Management Public Finance Alliance, and the Centralized Accommodation Management. Since these organs are backed by full faith and credit of the US government, the bonds are viewed as less credit risk, just like the US Treasury Bonds (Brown, 2006).

The bureau bond bazaar is regarded as a liquid souk where supplies can be procured and traded promptly and straightforwardly. However, various features make some agency bonds complex and more structured to the extent of reducing their liquidity, thus making them less lucrative for individual investors (Faerber, 2001). Firstly, most agency bonds are structured in such a way that they are paid semi-annually with a fixed interest rate or a predetermined token fee (Brown, 2006). Another important feature is that most agency bonds are offered as non-callable or bullet bonds, meaning that they are unalterable before the set maturity period (Pento, 2013). Despite the above structures of agency bonds that relate to fixed-rate tokens and con-callable bonds, agencies often structure their bond issues to meet the needs and demands of the investors. Here, the interest rates are adjusted periodically in response to market dynamics, the US Treasury yields index or the predetermined formula that limits the variations to which the coupon rate can change (Pento, 2013).

On the other hand, the non-coupon agency bond notes or ‘discos’ are issued by agencies with the aim of meeting short-term financial needs. They are given at a discount to the principal amount (Choudhry, 2006). These bonds are payable only after the maturity period. Shareholders who may sell them prior to this period risk making losses to their investment.

Another structure of agency bonds is the callable agency bonds, which offer the “step-up” coupon rates. The callable agency bonds provide a preset coupon charge, which cushions investors from interest rate risk by increasing the interest charges or coupon rates as the bonds approach maturity (Pento, 2013). These bonds are issued when interest rates in the market begin to go down.

Lastly, it is important for investors to understand that not all agency bonds are exempt from government taxations. Hence, this situation may affect the amount of interest that the investment in such bonds yields for the shareholder (Faerber, 2001). For instance, some of the major GSEs such as the Freddie Mc and Fannie Mae are taxable organizations and publicly traded companies, which are taxed at the rate of stocks. This taxation can significantly affect the amount that an investor expects to obtain from investment through bonds into these organizations.

Municipal Bonds

Municipal bonds denote the debt obligations that cities, counties, states, and other governmental entities offer to fund public projects such as learning institutions, sewer systems, water supply systems, roads and rail maintenance, and health institutions among other purposes to benefit the public (Pento, 2013). Municipal bonds have specified interest rates, which are paid semi-annually while the principal amount is returned at a specified time after maturity. While some municipal bonds are exempt from federal and state taxations, others are not. In this case, some municipal bonds, which are taxable by the federal government, may be exempt from state taxation at the state of issuance. In other instances, the local government may tax municipal bonds. However, they may be exempted from federal government taxation (Pento, 2013). Depending on the structure, municipal bonds earn more returns to investors since they are viewed as more credit risk as compared to the US Treasury Bonds. However, an investor must consider all these factors before deciding to invest in municipal bonds.

Corporate Bonds

Corporate Bonds refer to debt obligations that are issued by private or public corporations to raise funds to sponsor various initiatives and projects such as business expansion and the purchase of new equipment and facilities among other reasons that have been established to benefit the business in the short and long-term (Pento, 2013). These bonds are taxable. Hence, all the interests that an investor is entitled to be taxed as per the state and federal tax laws that govern such activity. Just as other bonds, corporate bonds have a maturity period and an interest rate that is payable semi-annually (Choudhry, 2010). Corporate bonds are one way through which a corporate entity can raise finances. However, they vary significantly from supplies or shares since the former class (bonds) does not give the financier a tenure chance in a corporation. However, this difference is a significant advantage over overstock. When such a company faces financial difficulties, the debt holders are given priority. They are also cushioned from the losses since they are paid their dues, as opposed to asset owners who are shareholders who share the company’s losses or profits.

High-Yield Bonds

Buying a bond helps an investor to make returns through the offered interest rates. As previously mentioned, the amount of interest that bond issuers may offer is dependent on the issuers’ credit merit (Faerber, 2001). Minimal risks imply not only reduced interest fees but also less income to the debt holder. On the other hand, a low credit rating indicates a high risk for investors, as the bond issuer’s chances of default are higher. In this situation, high risks attract higher interest and hence higher returns to an organization (Choudhry, 2010).

High-yield bonds are issued by organizations that have weak balance sheets, which greatly affect their ability to pay back. Hence, they are forced to offer very high-interest rates to attract investors (Pento, 2013). In the US, such bonds are issued by organizations that do not meet the criteria for invest-grade rating as specified by investment agencies such as Moody’s Investors Service, Fitch Rating, or the Standard & Poor’s Rating Services. Investing in such organizations is a high-risk undertaking. Hence, high-interest rates are used to entice investors (Pento, 2013). If the organizations succeed in paying back the debt, the potential for very high earnings is very high for the investor.

Other Types of Bonds

Other types of bonds include mortgage-backed bonds, zero-coupon municipal bonds, callable securities, and foreign bonds among others. Hence, the diverse nature of the bond field calls for different approaches to defining various types of bond issues in a given country (Pento, 2013).

Why Bonds are needed

As part of the standard property categories that comprise supplies and money equivalents, the bond bazaar is the biggest of mentioned categories. It plays a significant role in any economy and business. Bonds are needed to fill important financial gaps and deficits that allow a government or organization to meet its obligations (Brown, 2006). For instance, the US government is in charge of major projects and programs that are geared to benefit the public. However, due to many reasons such as inflation, wartime expenditures, and other economic factors, the government can collect enough revenues through its programs such as taxation and other activities to the level of creating a major deficit whereby it may be difficult for it to finance critical programs without other financial aids (Choudhry, 2010). For the US government, bonds are a better option as compared to bank loans or other forms of financing where the high-interest rates end up costing the government highly. Since the government is viewed as risk-free, it can negotiate for low-interest rates, which end up making such bonds or financing less costly as compared to other forms of financing.

Bonds are also very important for businesses since they provide important avenues for attracting investors and finances that are needed for various activities such as expansion and/or buying new assets and equipment among other projects that are important to an organization’s survival and progress in its business area (Pento, 2013). Bonds are also highly tradable. Hence, investors can sell their bonds at any time. This situation gives them an option of making the bonds more attractive to investors. Therefore, they stand a chance to raise large amounts of money within a short duration.

Benefits and Costs of Taking Bonds

Various advantages are available to bond issuers as compared to other forms of financing such as loans. Bonds have restrictions and rules that do not undermine the companies or entities’ performance as compared to loans (Brown, 2006). For instance, with a loan, a bank often has restrictive measures that have been established to ensure that the borrower pays the loan. For instance, the restrictions, which are backed by legal terms and features, may often prohibit a company from going public or borrowing again among other restrictive terms that can greatly affect an organization’s performance (Faerber, 2001). However, in bonds, a company has the will to borrow more by offering new bonds, buying out other companies, or merging as long as it continues to meet its financial obligations to the debt holders.

On the downside, bonds also have their disadvantages and costs. For instance, many terms of interest or maturity are discussed at the beginning of the bond issuance. Such terms are not easy to revise in the course of the period of the bond (Brown, 2006). In this case, if a company faces major difficulties and fluctuations in the market, it may have difficulties paying out the due amount, yet it has no other alternative but to pay as agreed at the beginning of the bond.

Conclusion

Based on the above expositions, bonds have a long history. They have evolved greatly to become the largest of the three generic asset classes, including stock and cash equivalents. The US Treasury Securities organ is the world’s largest bond market. It is a key component of the US government’s avenues of accessing financing for its various programs and projects. Bonds are also issued by federal agencies and corporate organizations to support various relevant activities. As identified, each of the different types of bonds has its area of application and different purposes. Concisely, bonds form a very important part of any economy since they help to finance critical activities for governments and organizations.

Reference List

Brown, P. (2006). Introduction to the Bond Markets. Hoboken, NJ: John Wiley & Sons.

Choudhry, M. (2006). Corporate Bond Markets: Instrumentals and Applications. Hoboken, NJ: John Wiley & Sons.

Choudhry, M. (2010). An Introduction to Bond Markets. Hoboken, NJ: John Wiley & Sons.

Faerber, E. (2001). Fundamentals of the bond market. New York, NY: McGraw Hill Professional.

Pento, G. (2013). The Coming Bond Market Collapse: How to Survive the Demise of the U.S. Debt Market. Hoboken, NJ: John Wiley & Sons.