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Q: a few things I don't understand about government and corporate bonds ( Answered 5 out of 5 stars,   2 Comments )
Subject: a few things I don't understand about government and corporate bonds
Category: Business and Money > Finance
Asked by: gnossie-ga
List Price: $25.00
Posted: 27 May 2005 11:31 PDT
Expires: 26 Jun 2005 11:31 PDT
Question ID: 526382
We're talking here about the kinds of government bonds that Uncle Sam
sells to help pay for the budget deficit...

1.  Who sets the interest rates for government bonds?  Apparently it's
not Alan Greenspan.  Who is it?  The House?  The Treasury Department? 
I read that yields on 10-year notes are going up and down from 4.2% to
4.6%, etc.

Where is all this fluctuation coming from?  I thought these were sold
officially by the government, which only changed the interest rates on
them once in a while.  So two questions here, I guess:  who is
deciding what the interest rate is gonna be, and why is it getting
changed so quickly?

2.  What's the difference between a Treasury note and a Treasury bond?

3.  Normally, Treasury bonds are not protected against inflation,
right?  I hear there are special "TIPS" (Treasury Inflation-Protected
Securities) that are, but let's deal with the normal ones for a
second.  What moron would buy them?  I mean, if inflation is about 3%
per year, and your bond is gonna yield 4-5% after TEN years, what's
the point?  There's obviously something I don't get.

It seems that EVERYBODY would prefer buying inflation-protected
government bonds, but then I read that some financial advisor
recommends  that "at this juncture, the prudent thing to do" is buy
normal ones, not the TIPS ones.  Whot?!  What could possibly be the
advantage of that?  It seems like there would never be a reason to buy
a non-inflation-protected bond, at least not at what seems like a
paltry interest rate.  Obviously folks who buy these things are
getting their money back somehow, but I don't understand where from.

4.  How can a "corporate bond lose value"?  I read this statement from
time to time.  (We're talking here about bonds issued by a
corporation.)  Say I loan Intel $100, they give me a bond for that,
and they have to pay me back the principal in 5 years, plus some

Well, how could that waver in value?  (I'm obviously a newcomer to
this kind of stuff; forgive me.)  I can understand how it could
suddenly become worthless:  Intel goes bankrupt and they don't have to
pay back the principal.  But, as long as Intel's not bankrupt, how
could it fluctuate in value?  It seems cut and dried to me.
Subject: Re: a few things I don't understand about government and corporate bonds
Answered By: richard-ga on 27 May 2005 13:51 PDT
Rated:5 out of 5 stars
Hello and thank you for your question(s).

A good starting point in this area is
Bureau of the Public Debt
Frequently Asked Questions about Treasury Bills, Notes, Bonds, and TIPS ("FAQ")

1.  Government bonds (that is, Treasury bonds, bills and notes) are
sold by the government in an open bidding process.  So the original
issue price and interest rate is determined by what people and
institutions offer to pay.
From the FAQ:  "The Treasury Department sells securities at auctions
conducted throughout the year. To buy a security at one of these
auctions, you must place a bid. You can place your bid directly with
the government in a program called TreasuryDirect, or you can place
your bid through brokers, dealers, or financial institutions, in what
is called the Commercial Book-Entry System."

For example:

That's the original issue of the securities.  Then, there are enough
people wanting to buy and sell these that on the secondary market,
traders buy and sell previously issued securities.  It's mostly the
secondary market prices that you see quoted in the daily newspaper and
on the Web.  A number of factors, including anticipated inflation
rates and the prices of competing investments (stocks as well as
bonds) affect the prices that buyers are willing to pay.
Here's how Fidelity explains it:
Prices, Rates, and Yields

2.  Again quoting the FAQ, "Treasury bills are short-term obligations
issued with a term of one year or less. Treasury bills are sold at a
discount from face value and don't pay interest before maturity. The
interest is the difference between the purchase price of the bill and
the amount that is paid to you either at maturity (this amount is the
face value) or when you sell the bill prior to maturity.
"Treasury notes and bonds bear a stated interest rate, and the owner
receives semi-annual interest payments. Treasury notes have a term of
more than one year, but not more than 10 years. Treasury bonds are
long-term obligations with a term of more than 10 years."

3.  Quoting the FAQ, "TIPS, or Treasury Inflation-Protected
Securities, are securities whose principal is tied to the inflation
rate. They bear a stated interest rate, and the owner receives
semi-annual interest payments."
Why doesn't everybody buy TIPS?  Because if inflation stays low you'll
get a lower yield from them compared to security that isn't tied to
Consider two 5-year notes, one TIP and one regular
5-YEAR [TIP] NOTE  04-29-2005 04-15-2010 yield 1.200 
5-YEAR  NOTE  04-15-2005 04-15-2010 yield 4.046

4.  You're right in thinking that unless a corporation actually
defaults on a bond, for example by going bankrupt, then an investor
will receive all promised interest payments and a return of principal
at the end of the term of the bond.
But not everyone holds a bond to maturity, either because they buy the
bond intending to sell it early, or their circumstances change, or the
company's circumstances change for the worse and they sell for what
they can get in order to avoid the risk of a future bankruptcy.
A current example is GM bonds, recently downgraded to 'junk.'
"GM's bond prices fell after the downgrade. Bonds with an 8.375
percent coupon due in 2033 fell to 72.75 cents on the dollar from 73.5
cents before the Fitch action, according to MarketAxess."

Search terms used:
treasury bond auction
treasury bill secondary market
gm junk bonds

Thanks again for letting us help.  If any of this requires
clarification, please let me know.  I would appreciate it if you would
hold off on rating my answer until I have a chance to reply [and
please be patient, since I'll mostly be away from my computer during
this holiday weekend]

Google Answers Researcher
gnossie-ga rated this answer:5 out of 5 stars

Subject: Re: a few things I don't understand about government and corporate bonds
From: financeeco-ga on 27 May 2005 14:35 PDT
Off the bat, here's a tip: NEVER, NEVER, NEVER use the term "interest
rate" when talking about a bond. There are really two "interest rates"
relating to a bond: the COUPON RATE that is contractually fixed (a 6%
bond usually pays 3% of its face value semiannually); and the YIELD TO
MATURITY that is the actual rate of return to the investor. By using
the more precise terminology, it will help you learn and grasp the
concepts better.

Bonds are a single asset class that people can choose to invest in. In
order to attract investors, bonds must offer a decent rate of return
relative to other asset classes. Money pays a certain interest rate.
Stocks have a certain dividend and expected return. etc. The returns
on all of these assets fluctuate over time due to market conditions.

Say I can get 5% interest rate on an FDIC-insured CD. In order to
entice me to buy a bond, I must get a higher return (to compensate for
the additional risk). If there's a corporate bond on the market with a
3% COUPON RATE, why would I buy it? I can get higher monthly payments
with less risk. In order to entice me to buy this bond, its seller
must DISCOUNT the price. So I can buy a 3% bond for 90% of its face
value. Now, in addition to 1.5% of the face value every six months,
I'll get a "free" capital gain of 10% when the bond matures.

The bond has discrete, predictible cash flows. It's important to
remember that money in the future is less valuable than money now (the
concept is called TIME VALUE OF MONEY).

When you buy a bond, you know the price today and all of the future
cash flows. The bond's YIELD TO MATURITY is the number that equalizes
the price you pay today to the actual VALUE (time value of money) of
cash flows you will receive. The YIELD TO MATURITY value that balances
the equation is an interest rate-like number (it will usually be
between 3% and 10% annually).

On the sellers side, they know the returns of other asset classes and
other bonds, so they will set a selling price what produces an
appropriate YIELD TO MATURITY in order to attract buyers.

Note: in general, a bond whose coupon rate is lower than prevailing
market rates of return will generally trade at a DISCOUNT to its face
value, b/c investors must get some "free" capital gains in order to
justify the lower semiannual payments. A bond whose coupon rate is
higher than prevailing rates will generally trade at a PREMIUM to its
face value, b/c buyers must "pay" (in the form of future capital
losses) for the higher semiannual payments. This is all just proof
that there's no such thing as a free lunch. Regardless of the timing
of cash flows, yields will be appropriate across the same asset class.

There's an inverse relationship between a bond's price and its yield
to maturity. When price rises, YTM falls (b/c you're paying more for
the same set of cash flows, so they must be reduced less by the TVoM
equation). When price falls, YTM rises (you're getting the same cash
flow for a lower price).

1. (note that this answer refers to T-Bonds, not T-Bills... more on
that later). When the Treasury goes to the market to raise money, it
has a dollar value target of how much money it wants to raise. It
prints new government bonds with a coupon rate that's close to the
current yield to maturity of similar government debt in the market. In
a perfect world, when these bonds are actually sold, they will be
bought exactly at par (no premimum or discount), b/c the coupon rate
matches current market yields. In practice, there's a timing lag
(think of it as the delay as the printer actually prints the bonds and
drives them to the exchange), so new government debt is usually issued
at a slight premimum of discount. In brief, the market for exisiting
government debt is what determines the coupon rate of new government

2. The answer above addresses notes vs. bonds. There are also
securities called T-Bills. These are very short-term. They actually
have no coupon rate (they don't pay any cash to the holder until
maturity). So they're sold at a relatively deep discount. All of the
return to the investor comes in the form of capital gains. This
structure is generically referred to as a zero-coupon bond.

3. There are real rates of return (r) and nominal rates of return (i).
The relationship is thus: i = r + inflation (this is actually an
approximation, but it works for the explanation). A nominal interest
rate is just a contractual paper rate. After you subtract out
inflation, you're left with the real rate of return. Going back to
earlier, when you buy a bond, you're accepting a NOMINAL yield to
maturity. Baked into that rate is some expected rate of inflation over
the life of the security. If you (or the collective market) is
guessing too low, the actual real return is less than expected (the
bond's seller benefits). If you/market is guessing too high on
expected inflation, the actual real return is more than expected (the
bond's buyer benefits).

TIPS are structured so the YTM you get today will be your REAL YTM,
b/c you get compensated for inflation. However, TIPS are still
bought/sold in a market, so supply/demand imbalances can distort the
picture. The supply of TIPS is tiny relative to the supply of "normal"
government bonds. Some people speculate that this is artificially
pushing prices higher, which in turn pushes yields down. So you've
still settled for an abnormally low YTM.

Others theorize that the "normal" bond market is guessing too high on
expected inflation, so you can get "free" returns by buying a
higher-than-justified nominal YTM.

4. Intel's bonds pay a set coupon. As market rates fluctuate, the
bond's price is adjusted to makes its YTM equal to market rates. Also,
an the market demands a premium (in the form of higher yields) for all
sorts of reasons. Think of bond pricing like this: 1) begin with the
YTM on US government debt of the same maturity. This is the closest
think to riskless debt. 2) add in a yield premium to compensate for
the fact that Intel's bonds are not riskless. (premiums are generally
the same for similarly-rated debt). 3) add in more yield premium to
address any Intel-specific risks (say they suddenly forecast drastic
drops in volume due to Chinese competition).

Factor 3 above is the cause of a lot of daily fluctuation in corporate
bonds. Say that bad news increases the risk of default from 2% to 5%.
This isn't much of a change, but investors now need more yield to
compensate them for additional risk.
Subject: Re: a few things I don't understand about government and corporate bonds
From: gnossie-ga on 29 May 2005 05:14 PDT
Holy moly, that's quite a comment!  Gimme a day or so to study what
you have written...

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