So, this is "Bonds 101: Starting from Scratch."
What are Bonds?
A bond is basically a loan. Everybody is familiar with their mortgage. A mortgage is a bond. You borrow money from a bank to buy your house. Corporations borrow money from pension funds, individuals, to build new plants, to pay for employees, to pay for whatever they need to pay for. Governments sell bonds to pay for their needs, whether it's military or welfare, whatever a government needs to do to cover the needs that aren't met by the immediate tax income to the government, is made up by selling bonds.
The U.S. government is probably the champion bond seller of the world. Every month, they're selling, the number varies depending on their needs, but anywhere from $35 billion to $135 billion and sometimes more, sometimes less. We're kind of going through a funny period right now where they're starting to sell less because of the tax increases and the savings from the sequester.
But let's get back to the simple stuff, here, on the bonds side. So everybody knows what a bond is. Now, bonds have various maturities. We're all familiar with your mortgage. You have a 30-year mortgage or a 15-year mortgage, which basically says the bank loans you the money for 30 years and you use it to buy a house and you pay it off slowly over those 30 years, along with principal, which is the original loan, plus the interest that the bank demands for lending you the money in the first place, which, oftentimes, can be fairly significant.
There's something in the bond market, obviously, we're going to start talk about U.S. Treasury Bonds, now, since that's what most people in the capital markets are trading. U.S. bonds are a sovereign debt. They're from a sovereign nation, the United States. Most every country in the world, they're all bond issues. Most people are familiar with German Bunds or British Gilts, French OATs. They all have their own sovereign debt.
All debt structures from zero-day maturity, or one day, two days, three days, you can borrow money over those maturities, have different names. Treasury bills are very short-term from one day out to one-year maturities. Treasury notes go from two years all the way out to 30 years, at this point.
The bond market has grown quite a bit over the last 20, 30 years since I've been in the markets. These days, a lot of trading, more so than ever before, is going on in exchange-traded funds. You can track darn near every bond type and maturity through ETS. We trade U.S. government Treasury bond and note futures, which trade on the Chicago Board of Trade at the cmegroup.com. You can look those up. The CME Group website has a ton of information in terms of bonds and bond futures, bond futures options. It will get very complex as we move forward through these lectures, here.
Yeild Curve. Bond Pricing: Interest Rate vs Maturity Time
We all understand that the longer you borrow money for, the more risk there is that specters may affect the price that you paid for that bond.
Price is implicitly related to interest and it's also related to time. We draw structures or graphs of what we call the yield curve. It's very
simple: the longer-dated the bond is, the more risky it is and the higher the interest on it. Now, we're looking at U.S. government bonds right now that are yielding about 270, 2.7% a year. Treasury bills are yielding 8 basis points all the way out to 20 basis points, roughly.
Treasury notes go from 20 basis points, 30 basis points around the 2-year maturity all the way to, like I said, the 275, roughly, for the 30-year bond.
If you draw a graph of that, it's called the yield curve. I hope you guys can see this graph. Now, as the yield goes up on this side of the chart, this is yield, it goes up from zero percent all the way up to 3 percent in the case of U.S. government bonds versus the time frame. It's pretty simple. From zero maturities here, all the way out to 30-year maturities here, that's called a normal-yield curve. That structure will change at times and that's going to be another lesson, at this point.
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