Virtually any financial arrangement involving the current transfer of resources from a lender to a borrower, with a transfer back at some time in the future, is a form of bond. Car loans, home mortgages, even credit card balances all create a loan from a financial intermediary to an individual making a purchase—just like the bonds governments and large corporations sell when they need to borrow. | |
| When companies like General Motors, AT&T, or General Electric need to finance their operations, they sell bonds. When the U.S. Treasury or a state government needs to borrow, it sells bonds. And they do it billions of dollars at a time. In 2003 alone, U.S. corporations raised $750 billion through bonds, adding to the nearly $13 trillion they had already borrowed. Federal, state, and local American governments have more than $11 trillion in outstanding debt as well.1 The ease with which individuals, corporations, and governments borrow is essential to the functioning of our economic system. Without this free flow of resources through the bond markets, the economy would grind to a halt. Historically, we can trace the concept of using bonds to borrow to monarchs' almost insatiable appetite for resources. To maintain lavish lifestyles, fight wars, and explore the globe, kings, princes, and other rulers drew on every available source of financing. Even with these incentives, after thousands of years of civilization only a few possibilities had been developed: outright confiscation; |
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taxation, which is a mild form of confiscation; debasement of currency, in which people are required to exchange their coins for ones that weigh less—in effect, a tax on currency; and borrowing. Monarchs who borrowed directly from international bankers frequently defaulted or failed to make the loan payments they had promised. Between 1557 and 1696, the various kings of Spain defaulted 14 times. With that track record, it's no wonder they had to pay interest rates close to 40 percent.
The Dutch invented modern bonds to finance their lengthy war of independence against those same Spanish kings who defaulted on loans in the 16th and 17th centuries. Over the next two centuries, the British refined the use of bonds to finance government activities. The practice then spread to other countries. Alexander Hamilton, the first Secretary of the U.S. Treasury and the man whose face appears on the $10 bill, brought bonds to the United States. One of Hamilton's first acts after the formation of the U.S. Treasury in 1789 was to consolidate all the debt remaining from the Revolutionary War. This resulted in the first U.S. government bonds. While the depth and complexity of bond markets have increased in modern times, many of their original features remain. If we want to understand the financial system, particularly the bond market, we must understand three things. The first is the relationship between bond prices and interest rates (yet another application of present value). The second is that supply and demand in the bond market determine the price of bonds. The third is why bonds are risky. Let's get started. 1These numbers come from the Flow of Funds Accounts of the United States, published quarterly by the Federal Reserve Board. For U.S. corporations, the new borrowing is the sum of Table F2 line 19, "Credit Market Borrowing by Nonfinancial Business," plus Table F3 line 6, "Credit Market Borrowing by Private Financial Sectors,'' and includes commercial paper as well as long-term bonds. The quantities outstanding are the equivalent values from Tables L2 and L3. For the government, the numbers are the sum of Table L2 lines 2 and 23 plus Table L3 line 2; these include debt issued by government-sponsored entities. | |
