Selling Debt - How Bonds Work
To anyone used to retail commerce, the idea of "buying debt" sounds somehow wrong. Ask the ordinary person invested in mutual funds or real estate to explain bonds and you will normally hear a certain degree of stuttering. The simple answer is that bonds are certificates that represent debt. And when good companies go bad, it is easier for bondholders to get repaid than hapless stock investors.
Size of the bond market
The American stock market represents about $46 trillion in equity. The amount invested in the bond market is equal to that or larger, depending on the source of information.
Creating ordinary debt
Bonds are easy to understand once collectors understand that debt can be bought and sold just like any other asset. Let's start with a simple story.
Imagine you own an old truck you no longer use. At this point, you are an "equity owner" because you own the truck.
A family friend has a teenager who just earned a driver's license. The kid needs transportation, knows you have an extra truck, and makes you an offer of $2,000. You trust the kid (and the family) and make a deal to sell it for $100 a month over 20 months. You write up a short contract, the kid agrees, and gives you the first hundred dollars.
Just like most auto lenders, your contract specifies you keep the title and the kid keeps the vehicle insured until the loan is fully paid. You and the buyer sign the contract. Once you handed over the keys, you became a "lender" (also known as "creditor") and the teenager became a "borrower."
Fast forward five months
You received five $100 payments during the first five months which you promptly spent on golf. You learn that one of your friends has a near-new riding lawnmower for sale and you need one. He is willing to sell it for $1,000, but you don't want to take money out of savings. However, you still have a contract with an unpaid balance of $1,500. You'd rather have the lawnmower today than $1,500 spread over the next year and a quarter.
It turns out, your friend has loaned money before and is willing to trade his mower for your contract. After all, he is familiar with the kid and his family and reasons they are an acceptable risk. You trade your loan contract and truck title to your friend, and motor away on your riding lawnmower. You tell the kid to pay your friend instead of you. Everyone's happy.
After signing both the title and the contract over your friend, you switched positions again. Your friend is became the creditor and you became an equity owner again. You may not have known it at the time, but you just sold debt to your friend.
The bond market works the same way. Paper bonds (now fully electronic) represent debt that companies promised to repay. Over 500 billion dollars in debt is bought and sold in the U.S. every day.
Who writes the contact?
When you sold your truck to the teenager, you probably bought a pre-printed contract from an office supply store. Or maybe you purchased a contract from an online source that was legal in your state. Either way, you protected yourself against non-payment. You made sure the truck stayed insured and you kept the title in the event the kid stopped paying.
If you have ever purchased large assets and needed to borrow money, you know that lenders always slant their lending terms in their favor. Yes, state and federal laws compel banks, credit unions, and hedge funds to be "fair" to you. However, to be clear, they are more fair to themselves. Unless rank amateurs, lenders structure terms of repayment and interest in their favor. Borrowers always have the option of accepting those terms or going elsewhere. When dealing with "small" amounts of money, borrowers generally accept whatever terms lenders stipulate and rarely shop around for better deals.
Attitudes change when monetary amounts climb into the millions or hundreds of millions of dollars. The more money involved, the more borrowers want to write the contracts to favor themselves. When that happens, lenders have the option of saying "yes" or "no." When large companies become the borrowers and investors become the lenders, then we move into the world of corporate bonding.
Typical retail lending is about lending "small" amounts of money to huge numbers of borrowers where lenders write the terms of contacts. Typical corporate borrowing is much the opposite; it is procuring huge sums of money from large numbers of investors and companies, in the roles of borrowers, write the contracts.
In the corporate world, the promise to repay – "my word is my bond" – is both literally and physically true. Bonds are the contracts corporate borrowers write. When companies write bonds, they are writing contracts, and they state all the necessary features such as interest rates, collateral pledged, repayment dates, and interest payment dates. They also write the remedies in the case they fail to fulfill their promises.
When investors buy bonds, they are effectively lending money and receiving repayment contracts from companies. Bondholders are lenders.
Corporate borrowing is greatly more complicated than buying cars, houses and boats, both in scale and in the ramifications for not paying. The process, though, is still about needing money, credit worthiness, and the ability to pay. Whether borrowers are corporations or public entities, all need to structure terms as favorably as possible to attract investors while doing as much as they can to protect their own financial health.
Large borrowing entities such as companies, cities, states, and even countries know they must cater to investors who have thousands of investing alternatives. They know their terms must seem reasonable and fair to large numbers of investors. Those borrowers can attract lenders (investors) by adjusting:
- amount of money to be borrowed
- interest rates offered
- numbers of years until repayment
- frequency of interest payments
- collateral guarantees
Large and stable borrowers have capabilities of offering additional incentives such as convertibility into other bond types, rate adjustability, and premium allowances in the event of early retirement, etc. (See additional bond types at Glossary.)
Inflation during the American Civil War (1861-1865) hit bond investors especially hard. Between 1860 and 1866, the dollar lost half or more of its value. (Estimation is difficult because of pronounced regional differences.) After incurring such large losses of value, bond investors became understandably concerned about lending money again without additional protections.
It was widely believed that gold would always retain an acceptably constant buying power. Corporations used that assumption and began promising to repay their bonds in gold coinage instead of ordinary currency. The earliest recorded railroad bond that promised to repay principal and interest in gold was issued in 1865. The number of bonds denominated in gold increased steadily until the Panic of 1873 radically dried up investments. A depression followed (at the time, popularly known as the Great Depression) and ground railroad expansion to a halt. Investments gradually recovered and the popularity of gold bonds increased even more.
Evidence from extant collectible bonds suggest more railroad gold bonds were issued in the 1890s than in any other decade. Surviving collectible bonds also suggest a diminishment after 1900, but that observation is not easily confirmable.
Trucking and another recession in 1920 siphoned off short-haul railroad traffic. In response, it appears corporations shortened repayment periods in order to attract more investors. The great Wall Street stock market crash in October, 1929 affected the entire planet and drove international gold prices higher than the fixed U.S. gold price. The difference in gold prices between the official fixed American price and variable global prices became a monumental problem for corporations.
The number and types of bonds known to collectors suggest that companies had denominated 87% of their railroad bonds in gold between 1890 and October, 1929. High international gold prices forced almost all countries to abandon their gold standards between 1930 and the end of 1932. At the same time, the U.S. continued to pay its foreign debts in gold at its immovable $20.67 price. Financiers could almost hear a giant sucking sound coming from Fort Knox.
The U.S. government was having huge problems paying all its gold-denominated foreign debt, so think about railroad companies. By late 1932 and early 1933, the price of gold and the fluctuating world market had sometimes U.S. prices by 40$, and occasionally even more. In the face of dwindling U.S. supplies, how many railroads, if any, could have afforded to purchase gold on the open market to repay their bonds in metal?
On April 5, 1933, Franklin Roosevelt's presidential executive order limited private ownership of gold to $100 as an effort to stymie hoarding of gold coinage. Two months later on June 5, 1933, Congress passed a law that abrogated (cancelled) every clause in every U.S. contract that specified repayment in gold. In other words, the government outlawed repayment of bonds in gold coinage.
Ultimately, the U.S. gave into world pressure. On January 30, 1934, the U.S. raised its standard price for gold from $20.67 per ounce to $35. (See more detailed discussion at Gold bonds and frauds.)
Collectors might find it confusing, but almost fifty railroad gold bonds are known dated after June 5, 1933. Those bonds are actually replacements for earlier bond issuances. Legally, bonds could not be paid in gold, However, bonds are considered legal contracts and, as such, it is illegal to change wording, even on replacement bonds.
Bond certificates represent the crucial terms of final contracts that companies devise. Anyone who has bought real estate is familiar with the bulkiness of typical sales contracts. One can safely assume that bond contracts for many millions of dollars are more robust than can be represented on a single page. Therefore, most bonds reference additional documents, typically mortgages, that are available for inspection upon request.
Selling debt to investors
Other than perhaps the reputations of corporate officers and treatments of passengers, railroads usually had mimimal relationships with private investors. Most companies needed "underwriters" to help sell their debt. Underwriters were typically large commercial investment banks, savings and loans, and trust companies. Their roles were to find sufficient numbers of corporate and private investors willing to risk money. Of course, underwriters were paid for their efforts, often by purchasing entire bond issuances at discounts. Be assured that underwriters were also good at assessing the reality and risks of bonds issuances. They were definitely not going to buy hundreds or thousands of bonds without foreknowledge!
Re-selling discounted bonds were how underwriters made money, so they were good at estimating how successful their selling efforts would be, given the terms presented to them by companies. A small number of specimen bond certificates are recorded in this database that show two certificates of identical design, the first with terms that probably proved inadequate to attract sufficient numbers of investors. The second was usually printed a year or two later with more attractive terms. Research is would be needed to determine whether second sales attempts were more successful.
Investors' purchase prices
It is easy to assume that bonds were normally sold at denominations indicated on bonds. While many bonds certainly sold for face value (also known as "par value"), many more were not. Underwriters, institutional investors, and big-name investors often received volume discounts. Additionally, prices might have been lowered or negotiated in the face of market scares. Collectors will notice fewer bonds were issued during recessions and depressions and more during high-flying periods like the "gay nineties" and the "roaring twenties."