What You Should Know
The Role of Bonds in Europe
The next time you go for a walk or drive around your town, take notice of the changes taking place. See if a new road or bridge is being built or under major repair; perhaps a new school building is under construction; or maybe an office building is going up on an empty parcel of land; or a factory is expanding its operations with new machinery or warehouses.
All of these projects and many more like them are examples of bonds at work on behalf of governments and businesses. Before people are hired, earth is moved, concrete poured or walls put up, the money to pay for the work must be in place. Chances are a bond issue raised the funds to get the project started.
Infrastructure is a term that covers roads, bridges and transportation systems as well as the power plants that light and heat our homes, the reservoir and pipes that bring us water, or the sewer system that maintains sanitary conditions, among many other examples. Without bonds to finance infrastructure renovation and replacement in a timely way, these systems would crumble and the world would be a more dangerous, unhealthy place.
We all pay taxes to keep the government operating and providing needed services. But the amount of taxes the government collects during any period of time can vary greatly with the condition of the economy. Nevertheless, the military, the police, the hospital staff, the school teachers and yes, the tax collectors, must all be paid on time. In addition to financing long- term infrastructure projects, issuing bonds also helps government manage the ebb of its cash flow.
Bonds are one of the ways our public and private institutions borrow money, billions and billions of Euros and pounds. Direct borrowing via loans from commercial banks and other financial institutions is another way. However, bonds offer greater flexibility to investors as they can be sold to other investors in the secondary market if an investor wishes to recoup its capital before maturity. Commercial banks lend money on the basis of deposits of their customers and usually require their customers to lock in their deposit for a set period of time (e.g. 90 days) which therefore, does not offer the same degree of flexibility to the depositor.
Bond investors, therefore,—the people and institutions that buy the bonds—are the lenders. The bond issuer promises to repay the bond investor for the amount borrowed, also known as the principal or the bond’s par or face value, on a certain future date, known as the redemption or maturity date. Since a Euro today is worth more than the promise of a Euro tomorrow, bond issuers must also pay the investor interest in annual or semi-annual payments at a defined percentage rate known as the coupon rate. For the issuer, the interest expense is the cost of borrowing; for the investor, the dependable interest income is compensation for lending the money.
The biggest customers for purchasing bonds are investment firms and financial institutions such as insurance companies and banks, which buy bonds to have stable sources of cash flow to pay the obligations from the policies they sell. Both government and business also have big pension obligations to their retired employees. These pension funds also buy bonds to make sure the money is there when it is needed to keep checks rolling out to beneficiaries to secure their retirements. These large investors depend on bonds for the cash flows they need to meet predictable obligations. Individuals can also purchase bonds whenever the government or corporations offer them for sale. They may do this directly, provided they have enough to meet the minimums for investment, or indirectly through bond funds that pool investors’ money to invest in a portfolio of bonds.
As investments, bonds can provide individuals with a means of preserving their capital and earning a predictable return. Bond investments can create steady streams of income from the investment payments prior to maturity. Bonds can also provide downside investment protection against the more volatile movements of the stock markets. A diversified investment account should include some fixed income securities, either directly or through a bond investment vehicle such as a bond fund.
Not all bonds are the same, however. Their credit quality depends on the issuer’s relative ability to pay the interest and return the principal as promised. The better the reputation, the less risk, so the less interest paid on the bond--but the more certainty that investors will receive all they are owed. For this reason, bonds offered by some EU governments and the UK and US governments are generally considered the safest in the world for investors. Strong economies, public disclosure of budgets and a long tradition of reliable payment, and the power to raise taxes and print money are the factors contributing to their high credit ratings.
For corporations the story is similar except that companies always pay a higher interest rate than the highest rated governments because companies cannot offer the same guarantee of repayment. Companies with financial strength, a history of success, good business practices, and a track record for paying debts, issue bonds with lower interest rates than companies with lesser credit ratings.
Bonds are not only a way to invest and earn a return on your money; they are also a way to invest in the security of nations, the growth of economies, and the expansion of businesses. Regardless of who issues or invests in them, bonds play a critical role in the daily economic life of Europe and the globe.