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Invstr Basics: Bonds and Interest Rates

by | Oct 12, 2017

BONDS

A bond is an IOU (I owe you) and is a type of debt. In contrast to when a bank loans to you, if you buy a bond, you act as the bank. Essentially, through a bond purchase, you are loaning your money, usually to a government or business, and they promise to pay you back over the long term, paying you interest along the way, similarly to how a bank does when it pays you interest for depositing your money with them in an account. In the opposite fashion – when you take a loan from a bank, you agree to pay it back and you pay interest on top of it. To put it simply, bonds are used by governments and businesses to borrow money.

The price of a bond provided by a government depends on their creditworthiness – in the same way as a borrower must qualify for a loan by proving they will be able to pay it back in future, governments are also vetted or ‘rated’ by agencies to determine whether the price of the bonds they issue is fair. For example, a strong, stable country with robust legal and political systems combined with a growing economy would charge more for government debt than an unstable one.

Throughout history, governments have used bonds in order to fund various endeavours including wars, which were highly expensive due to manufacturing costs. By encouraging people to buy ‘war bonds’ the government could borrow enough money from it’s citizens and the international bond markets to fully equip its military. During the first world war, allied countries had unfettered access to world bond markets, while Germany and the central powers had to rely on the domestic market alone because they were forcibly cut off from the international markets. Many believe this economic disadvantage (a comparative lack of funding for their war effort) is part of the reason they lost the war.

 

Bonds are generally considered to be safe, guaranteed investments, because the guarantor and provider of the bond is a country’s government. However, governments are not invincible, and they have the ability to become bankrupt or destabilized like an individual business can. Governments can borrow too much, create public unrest through unpopular policies and suffer from external problems they have little control over. 

If a government does become financially ineffective through any means, this can erode their ability to repay their creditors (in this case, bondholders – investors). The inability or refusal of a government to repay is known as a sovereign default. Government debt is also referred to as sovereign debt, and when a government is close to being unable to pay it’s debts this is known widely as a sovereign debt crisis.

A sovereign default is a huge negative for a country’s economy. The failure of the leading political institution of a country signals a breakdown in it’s role as a failsafe in extreme circumstances. A  government should be able to provide support to all sectors of an economy, and provide a safety net for society, but a sovereign default causes people to lose faith in its ability to govern, and can also lead to huge falls in foreign investment into the country. Bonds can then become essentially worthless.

 

Argentina is an example of a country that suffered repeated sovereign debt crises between the late 1980’s and early 2000’s, after repeated economic downturns caused by a collapse in commodity prices and other structural failures caused massive public unrest and economic destabilisation.

The often changing Argentine Government tried to step in and slow the rapid contraction of the economy throughout the period, but inflation and unemployment reached record levels. Amidst widespread panic, the government began to default on its foreign debts, and by 2001 people began withdrawing as much money as they could from their bank accounts, trying to protect their savings. Fearing a major bank run (pictured) in the country, the Argentine government froze cash withdrawals from banks to prevent them losing massive amounts of capital and becoming insolvent. The government defaulted on $82bn worth of sovereign bonds in 2001 at the peak of the crisis, and only started repaying most of the money in the last decade after the economy began to recover.

INTEREST RATES

Interest rates, or base rates, are the amount in percent that is charged on top of a loan or other payment. It is the reward for lending and the cost of borrowing.

Under their remit to maintain price stability and keep economies on an even keel, national interest rates are usually decided by a central bank, like the Bank of England, U.S Federal Reserve or European Central Bank. One could say that the state of the economy actually determines rates, because external and internal influences on the economy will inform the decision of the central bank on where to go with its monetary policy. For example, a central bank might decide not to increase interest rates in a time of economic contraction, or increase them in so called economic ‘good times’. 

However central banks like the Federal Reserve (or ‘Fed’ as it is commonly referred to)  do not control the economy or all of the interest rates within it, only certain aspects such as the interest that banks pay when lending and borrowing to and from each other (or the ‘overnight’ rate).

Interest rates across the world are at very low levels, which means that those who deposit their money in bank accounts are not reaping much of a reward (return) for doing so. This has led many more people to take an interest in the stock market as a way of making a return on their savings. 

 

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ALL RIGHTS RESERVED © INVSTR LTD. 2017

Risk Disclosure:
Invstr is a technology platform, not a registered broker-dealer or investment adviser. Invstr does not offer its own recommendations of any security or provide its own research to any user regarding any security transaction or order. Brokerage services, including fractional trading of US securities, are provided to Invstr users by DriveWealth LLC, a regulated member of FINRA/SIPC. DriveWealth may not establish investment accounts to residents of certain jurisdictions. For more information, including disclaimers, risk and transaction fees click here. Please note, investing involves risk and investments may lose value. Past performance does not guarantee future results.

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ALL RIGHTS RESERVED © INVSTR LTD. 2017

Risk Disclosure:

Invstr is a technology platform, not a registered broker-dealer or investment adviser. Invstr does not offer its own recommendations of any security or provide its own research to any user regarding any security transaction or order. Brokerage services, including fractional trading of US securities, are provided to Invstr users by DriveWealth LLC, a regulated member of FINRA/SIPC. DriveWealth may not establish investment accounts to residents of certain jurisdictions. For more information, including disclaimers, risk and transaction fees click here. Please note, investing involves risk and investments may lose value. Past performance does not guarantee future results.

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