To fully understand these markets, it helps to know why they exist as they do. And while it is true that bond brokers speak English, they use expressions that act as shorthand, creating an often inscrutable language in the process. To make learning their lingo and the forms it describes interesting, we trace the development of the words through bond history.

Financial language derives from a vocabulary created over the centuries. This vocabulary is particularly puzzling to those new to marketable securities based on debt: namely, bonds, notes, bills, and other fixed-income investments. Based on U.S. case law, a bond, according to Black's Law Dictionary, is "a long-term, interest-bearing debt instrument issued by a corporation or governmental entity, usually to provide for a particular financial need; especially, such an instrument in which the debt is secured by a lien on the issuer's property."^[28] This is the definition we'll use in this book. All the following terms can be subsumed under the general heading of debt:

Most of the earliest legal codes sought to limit the use of credit or to prevent it altogether. The biblical Israelites did not permit lending at interest. Ancient South Indian literature reviled usurers and set interest limits. However, merchant activity requires the use of loans. The earliest use of loans in trade was in the form of bills of credit. Merchants financed their trade with written promissory notes entitling them to get money in distant ports. That way they didn't have to carry hard currency with them.

During the Dark Ages, merchant activity for all intents and purposes ceased. In addition, Charlemagne became the first ruler to prohibit all usury. If the result of lending was considered usury, the punishment was death. The Catholic Church effectively prevented all above-board acts of lending and borrowing, except as conducted by the Church itself.^[32] The Church had liquid capital that it lent to nobles and secured the debt with their land. The loan was called a "land gage." It was a live gage when the land's revenue repaid the debt and a mort gage (mortgage) when it did not.

By the fifteenth century, the pressure to allow borrowing was intense. With credit scarce and tax revenues falling short, as usual, kings and popes resorted to creative money-raising schemes to finance their armies, wars, luxuries, and political ambitions. To finance the monarchs' needs, they created merchant banks. In lieu of interest, the banks compensated the lenders by participating in the kings' monopolies and by franchises, special privileges granted to them^[33]—much as with venture capitalists today in their role as financiers to emerging enterprises.

After the Protestant Reformation in 1517, interest became an acceptable form of payment in Europe, making lending and borrowing easier. Interest was then accepted as compensation for risking the loss of borrowed funds and the possibility that the funds could be put to better use elsewhere. Catholic countries resisted the acceptance of interest. It wasn't until the early nineteenth century that the Holy Office decreed that anyone could take interest at rates defined by law. As recently as 1950, Pope Pius XII attempted to eradicate the stigma of the past in formally declaring that bankers "earn their livelihood honestly."^[34]

Islam's Shari'a law still does not permit the use of interest. Despite that, however, Muhammad Yunus established the Grameen Bank in Bangladesh in 1976 to provide microcredit to the impoverished. For this work, he won the Noble Peace Prize in 2006.

Today, negotiable loans pay interest. Black's Law Dictionary defines interest for money as "the compensation fixed by agreement or allowed by law...especially, the amount owed to a lender in return for the use of borrowed money."^[35] From Roman times, a distinction has been drawn between usury (the price paid for borrowed capital) and interest. Usury was considered to be profit. It included being paid more than the legal limit and/or with the purpose in mind to get more. Interest, on the other hand, was associated not with profit, but with loss. It was compensation for the loss of the use of money. At first, it was levied only if the loan was not repaid on time. Later, there were other qualifying reasons. For example, if it was viewed as a wage, compensation for the time and effort in making the loan, then it became acceptable to levy interest from the beginning.

Today, usury is defined as "an illegally high rate of interest."^[36] You are compensated through the payment of interest when you lend money by buying a bond. You find out at the time of purchase whether you will receive interest monthly, semiannually, or only when the bond comes due. In the United States, state law defines usury; however, the parameters defining usury are not the same in all states.

By the time Europe's age of exploration began in the sixteenth century, many of the concepts underlying today's bonds were already in place. The term bond, for example, is not used when a loan is made to an individual. Bonds are negotiable—they can be bought and sold. Central governments and their agencies, supranational governmental agencies such as the World Bank, state and municipal governments, and corporations are the only entities that issue bonds.

Our large-scale bond markets were based on patterns developed in Venice and other merchant towns in Italy and later on the financial success of the Dutch cities of Antwerp and Amsterdam, where a popular government was able to pledge the resources of a town, province, or nation. In the eighteenth century the English made two improvements to the Dutch systems of finance. First, the English clearly stated on each issue how much money was being borrowed, when the bonds would come due, and if there were any special terms that were part of the loan. For example, a special feature might be the issuer having the right to call in the bonds before the redemption, or due date. Second, they did not change the terms or features of the bonds from one issue to another. Once you understood the nature of the bond, you could buy any subsequent bond without having to consider the terms of the loan. Furthermore, the issues were for large amounts of money, enabling large-scale investors to purchase blocks of bonds to meet their investment needs instead of buying many little issues that each required analysis.^[37] Today, the Treasury and Euro markets most reflect these advances. Issues of bonds by large corporations can also approximate this ideal.

Since colonial times, bonds have been part of American history. Although the colonists lived in relatively basic conditions, they had the heritage of English law and finance to help shape the nation. England, whose bonds were primarily issued to pay for wars, laid the debt for the Anglo-French War on the doorsteps of the colonies. Massachusetts was the first colony to offer bonds to cover its costs. In 1690, Massachusetts issued paper to help pay for its share of the debts incurred by all the colonies while helping the British fight a war with the French Canadians. The attitude of the English was that it was a war to protect the colonies, so the citizens of the New World should bear the responsibility of the debt.

Massachusetts's first issue was successfully repaid from tax payments. (Today we call municipal bonds backed by property and other tax receipts "general obligation bonds," in that they are the obligation of everyone in the political entity that issued them.) Seeking other ways to raise revenue, in 1744 Massachusetts became the first colony to use a lottery to help pay off the war debt. The English Act of 1709 prohibited the use of lotteries in England, but this law did not apply to the colonies. They passed their own laws limiting or prohibiting its use later on. If the lottery was a revenue stream guaranteed for the repayment of bonds, we would call those bonds "revenue bonds" today. However, the lottery was just a means for the government to raise more funds. Massachusetts had a successful lottery; the one in New York two years later failed.

In keeping with the informal character of business in the colonies, a group of savvy Boston merchants decided to issue their own paper money in 1733. A set amount of silver, which could be redeemed after ten years, backed these bonds. When the price of silver increased by almost 50 percent above the redemption price, these notes appreciated in value. In this case, the issuer (the borrower) bore the risk of inflation. If there is inflation, it is usually the lenders (the bond buyer) who suffer, because they are repaid in depreciated currency.

Between 1751 and 1764, England put a stop to the issuance of paper money by the colonial governments. Unable to issue paper money, colonial governments issued Treasury bills instead, which were redeemable in gold and silver after two to three years. Like modern municipal bonds that are the general obligation of the state, actual tax payments rather than lotteries backed the bills. With the solid financial guarantee of the government, these Treasury bills did not depreciate.

The states still issue bonds today, but the term Treasury bond is restricted to bonds issued by the U.S. Treasury. After the American Revolution, one of the first acts of the U.S. Treasury in 1789 was the assumption of all war debts incurred by the states. Although the federal government agreed to pay, it did not have the money. In 1795, the Secretary of the Treasury Alexander Hamilton decided to adopt a method borrowed from the British: the use of a so-called sinking fund. In essence, the fund consisted of money set aside and invested to pay off a debt through the accumulation of interest. Sinking funds are still a feature of some revenue bonds today, although the money might not actually be set aside for the periodic debt recall. The funds usually kick in after fifteen years.

Hamilton's successor, Albert Gallatin, quickly figured out that the scheme was not working: interest on the debt was growing faster than the sinking fund interest that was supposed to pay off the debt. His solution was to reduce the debt by buying bonds in the marketplace if they were selling at or below face value. In so doing, he created the U.S. government's first open market operations. The Federal Reserve periodically engages in such activity today, buying and selling bonds in the open markets to expand or contract credit.

Gallatin also supported and planned the construction of roads and canals in the new republic. Direct federal funding for these plans ended, however, with the election of Andrew Jackson in 1830. The job of completing them fell to state and local governments, which had little experience and money to complete the costly projects.

Lack of experience, however, did not deter state governments from freely issuing debt for railroads, turnpikes, and other public improvements. It was commonplace in the early 1800s for banks also to issue notes to finance such projects. There were soon so many notes in circulation that they did not retain their value.

To create some clarity as to the strength of the issuer, John Thompson started the Thompson Financial and Rating Agency in 1842. He rated bank notes by sending his sons to banks to redeem notes for gold. If the bank refused, Thompson would condemn the note to death by writing about it unfavorably. From this beginning came today's financial tabloid American Banker.

At the time Thompson started his agency, a depression had hit the U.S. economy, and state revenues declined sharply. Payment of interest and principal was postponed, in some cases for as long as seven years, until all debts were repaid. (Principal is the face value of a bond, as opposed to the interest it pays.) Only two states, Mississippi and Florida, repudiated their debt at that time. Lest anyone think that lenders have short memories when they've been stiffed, it's reported that when officials from Mississippi went to London to sell a taxable Eurobond issue in 1987, they were told, to their surprise, that "the state's credit was no good. The state of Mississippi, the bankers explained, still owed London banks principal and interest on $7 million of defaulted state debt—sold 156 years earlier and repudiated in 1857!"^[38]

During the Civil War, the federal and confederate governments financed the war by selling bonds bought by the banks and sold to the general public. As the lines of credit evaporated, they issued fiat money—that is, paper money not backed by gold or silver. The Yankees issued greenbacks, the predecessors of modern U.S. currency.

Following the Civil War, economic life was harsh for the southern states. The difficulties were aggravated by the nationwide panic of 1873. Reeling under its impact and from the heavy load of bonds issued for railroads and so-called carpetbagger debt incurred after the Civil War, many states simply refused to pay a substantial portion of what was owed. The states relied on Section 4 of the Constitution's Fourteenth Amendment, prohibiting any state from paying debt incurred to fund a rebellion against the federal government. The Bond Buyer, a financial newspaper, reported that by 1873 a total of ten states had repudiated $300 million of principal and interest, with Virginia leading the pack, owing $72,220,000.^[39] The federal government refused to bail the states out.

Four outcomes of the profligacy of the states define the bond markets today.

It is important to note that in the present day as well, repudiation of debt is much more likely to occur when the populace does not specifically vote to incur the debt in the first place. Government officials always have visions of projects they wish to fund, some of which are basic improvements and others reflect special interests. Tax-averse citizens try to limit their local government's ability to issue bonds by writing laws placed on the ballot and approved by vote. As we'll explain later, creative financing methods circumvent those restrictions. California is at the forefront of these conflicting interests.

Perhaps the most significant event in the beginning of the twentieth century to affect bonds was the founding of the Federal Reserve in 1913. The Federal Reserve is a central banking system much like the one long used in Europe to pool bank reserves and create a lender of last resort. The initial effect of the Federal Reserve was to smooth out the fluctuation of short-term interest rates by making short-term money nearly always available. With the advent of World War I, the Federal Reserve took on the additional responsibility to manage the issuance of Treasury bonds, which were absorbed by banks, and the Federal Reserve System. Low interest rates soon became a government objective.^[40]

Corporate bonds became a major factor in the U.S. economy with the advent of World War I because of their high returns. By law, national banks had to hold Treasury debt in order to issue bank notes. In 1917, Treasury bonds yielded 2 percent, and corporate bonds, under no restraining regulations, were yielding up to 5 percent. Not surprisingly, the general public preferred the more lucrative returns of the corporate debt.

The Treasury needed to entice the public to buy its bonds, so that the federal government could finance the looming war. It came up with a creative solution, called Liberty Bonds, and sold them through banks. If patriotic Americans did not have the money to pay for the bonds they wished to buy, the banks lent it to them, charging the interest that the bonds paid. The American public bought the bonds on what is called margin, borrowing money to finance the purchase of securities. The call to patriotism led people to purchase Liberty Bonds, which in 1917 yielded 3.5 percent for fifteen-year bonds and 4 percent for the ten-year. Banks could use the bonds as collateral for loans, and credit flowed freely as the banks lent liberally for the time.

In 1920, fearful of inflation, the Federal Reserve used its powers to control this rapid expansion of credit by raising the discount rate. Subject to the vagaries of the market, the yield in 1920 on twelve-month Treasury certificates rose to 7.75 percent. Corporate bonds declined in value by 11 percent as interest rates rose from 4.95 percent to 5.56 percent, rates not seen again until 1967.^[41] Against such competition, Liberty Bonds issued in 1918, with a coupon rate of 4.5 percent, declined by 17 percent. Of Liberty Bonds' 18 million owners, an estimated 14 million liquidated their holdings due to rapid fluctuations in value.^[42] However, if they kept those bonds instead of selling them, they would have seen their value appreciate. The year 1920 marked the peak of prime bond yields, not seen for close to five decades before or five decades after that date. The holders of noncallable 100-year railroad bonds issued in the late 1890s with interest rates between 4 and 4.5 percent likewise saw their value plummet in 1920, but by 1946 those same bonds were worth 25 to 50 percent more than face value.

In the 1920s, nobody imagined bonds backed by mortgages, but in 1938 the creation of Fannie Mae, a government agency dedicated to the refinancing of unpopular long, fixed-rate mortgages, sowed the seeds. The creators could not have possibly realized that they were inaugurating an exciting new debt form that would evolve into the multitrillion-dollar mortgage-backed securities market.

During World War II, interest rates remained low for Treasury bonds, with fixed rates ranging from 2 percent to 2.5 percent for the 25− to 30-year bonds. Despite the low returns, when the highest federal income tax rate hit 94 percent between 1944 and 1945, the tax-exempt appeal of municipal bonds became magnetic.^[43] With 1945 came the end of the war and a suspension of long-term Treasury bond issuance for eight years. The so-called long bonds were eagerly bought in 1945 and again in 1999, when the government announced that it was going to pay down the government debt and reduce the supply of these 30-year bonds. Traders expected to see rapid price appreciation as their supply diminished.

The year 1946 marked the beginning of a bear market in bonds that ultimately ended in 1981, when interest rates peaked. The yield on prime corporate bonds rose from 2.46 percent in 1946 to a whopping 15.49 percent in 1981.^[44] The yields were even higher on sectors deemed riskier. The bond market experienced seven major price declines interspersed with six price rallies until yields on Treasury bonds peaked at 14 percent in 1982.

In the 1960s, Treasury bond sales to the general public were in the form of U.S. Savings Bonds, series E, F, and G. The Treasury was able to sell a 25-year bond at 4.25 percent interest, while the yield on a 25-month note brought 4 percent, a much better deal. The legal interest limit was 4.5 percent. By 1965, a wage-price spiral had begun, accompanied by ballooning inflation. Borrowers focused on the short-term markets because the Treasury could not sell long-term debt beyond the legal debt yield, and corporations did not want to borrow for high, long-term fixed costs.

By the late 1960s, holders of savings bonds began to cash them in at such a rapid rate that federal government bond sales netted less than the redemptions. The savings bonds had a fixed rate of 4.5 percent interest, while corporate and muni bonds yielded much more. To staunch the flow, the Treasury allowed the holders of low-yielding Victory Savings Bonds to exchange them for higher-interest H Bonds in January 1972. In 1980, still trying to stem the flow of funds, the Treasury introduced a new series of higher-yielding savings bonds with more limited liquidity. These are the well-known EE and HH Bonds.

Stand-alone mutual funds were beginning to attract investors' cash, and the money market funds competed with all the banks and savings and loans for ordinary deposits. The process, known as disintermediation, whereby assets are invested outside of the traditional financial institutions, was well under way. Another major change was the appearance in 1970 of the first mortgage-backed security in the United States, which was guaranteed by the federal agency Ginnie Mae. (For more on mortgage-backed securities, see chapter 9.)

The 1970s also marked the first appearance of so-called junk bonds. Before their first issuance in 1977, bonds of low quality that provided high yields were called "fallen angels." Viable corporations with investment-grade ratings that simply had fallen on hard times issued these bonds. Junk bonds, by contrast, were bonds of companies that had succumbed to hostile takeovers and were loaded with debt.

Trading in junk bonds was largely the work of Michael Milken, partner in the firm of Drexel Burnham Lambert Group. Milken figured that the savings and loans that invested in mortgages were failing because they locked in long-term debt in the face of rising interest rates. Their depositors were leaving for more lucrative returns elsewhere. The savings and loan associations (S&Ls) needed the quick infusion of income that junk bonds could supply.

In addition, junk issues offered corporations a lower-cost financing alternative than borrowing from banks. In the 1980s, leveraged buyouts and hostile takeover attempts used junk bonds as financing vehicles. Milken found that large, cash-rich conglomerates like RJR Nabisco could be bought using high-yield debt. The companies were then chopped into pieces that were sold to pay off the debt.

Milken created unusual debt forms to achieve his objectives. Increasing-rate notes, which were developed for the RJR deal, were one such innovation for short-term financing. These are notes that increased in yield the longer they remained unpaid. CDs and some corporate bonds now carry this feature. Similarly, step-up notes are temporary notes that cover a bridge loan until more permanent financing can be arranged.

Milken and Drexel were implicated in the insider-trading scandals of the late 1980s. Milken went to jail for ten years and paid a fine of $600 million; Drexel paid a $650 million fine.^[45] The high-yield market tumbled in 1989, and Drexel declared bankruptcy. The junk bond market nearly dried up. However, today there is again an active market for such debt, which prefers the name high-yield to junk. (For more on high-yield debt, see chapter 11.)

In the 1970s, high inflation, soaring interest rates, and heavy investments in junk bonds resulted in the bankruptcy of many banks and S&Ls. During the period 1979 to 1982, inflation reached double digits in three of those years, and interest rates were in the teens. Thereafter, however, following their peak in 1982, interest rates began a more than twenty-year decline. In that same year, the stock market began to rise with great price gyrations not seen before in the post–World War II world.

The peaking of inflation in that unprecedented 1979 to 1982 period, with resulting high interest rates and declining bond prices, imprinted the riskiness of bonds in the minds of investors and financial advisers alike. Bonds now had to pay more to compensate for this market risk. They were avoided, and the declining interest rates that eventually followed provided a big boost to the stock market. Yet a lot of money could be made in the bond markets as well. The dramatically falling interest rates that made stocks look attractive also created huge capital gains on bonds.

Had you bought bonds in the early 1980s, you would have made double-digit returns. As high interest rates later declined, prices of bonds bounded higher as investors sought to grab the yields before they sank further. According to a study by Salomon Brothers entitled "What a Difference a Decade Makes," bonds were the most profitable place to store wealth in the 1980s, averaging a return of 20.9 percent. Stocks were second best, averaging 16.5 percent. In the inflationary 1970s, real assets, such as real estate, natural resources, and precious metals, were king, and both stocks and bonds suffered negative returns.

The emergence of the information age profoundly affected the bond world. In 1969, the firm of Cantor Fitzgerald introduced the Telerate machine, which later became the electronic marketplace for Treasury bonds. In 1981, Michael Bloomberg developed the Bloomberg electronic information service that gave bond traders instant access to information about bonds and interest rates. That same year, J.J. Kenny Company established the first bond index as a yield benchmark for variable-rate bonds.

The information age also revolutionized the tracking of bond ownership. So-called bearer bonds were the equivalent of money. They had coupons attached for the payment of interest that was deposited in a bank account when the interest came due. The coupon rate was literally the value of the coupon when it was deposited in the bank.

After July 1983, all new issues of bonds had to be registered. This change coincided with establishment of electronic clearing among banks in 1983. When you own a registered bond, you receive a paper certificate, called a "bond," and a check in the mail, instead of clipping a coupon, on each interest payment date. (The rate of interest on a bond is still called the "coupon" even though they are no longer issued.) So-called book-entry bonds—bonds that can be held only in the custody of a financial institution—soon crowded out the registered bonds, as the clearinghouses rapidly transferred the ownership of securities without actually transferring paper. Registered bonds are still sometimes available, but only to humor those investors who must be dragged kicking and screaming into the electronic age.

New forms of bonds developed as well as techniques for risk management. From the junk bond arena and from corporations with better resources came high-yield zero-coupon bonds, payin-kind securities, extendable reset notes, convertible bonds, and different forms of preferred stock. The federal government developed inflation-protection TIPS for the broader market and I Savings Bonds for the general public. Federal agency paper in the form of Ginnie Maes and later forms of federally sponsored paper exploded as Fannie Mae and Freddie Mac created a secondary market in mortgages, thereby enabling you to invest in them. Staid, conservative municipal bond issuers looked for new sources of revenue to back their bond issues. They created moral-obligation bonds, which were soon displaced, first by lease-backed bonds and later by certificates of participation (COPs) to expand debt issuance. (For more on these bonds, see chapter 10.)

More novel still, financial innovators at the major financial firms created new trading instruments that depend on the value of other assets such as stocks, bonds, or market indexes. These so-called derivative assets, or contingent claims, are classified as futures or options. Bonds that had a given life, or maturity, paid a certain interest, and were of a certain quality were now sliced and diced in myriad ways. Interest payments were stripped from a bond and sold separately as zero-coupon (deferred payment) bonds. Bond portfolios were managed for their total return, and individual bonds were analyzed based on their various attributes in ways not done before.

This groundbreaking approach began around 1980 with the idea of selling the principal and interest of a bond separately, a technique called "stripping." The notion that existing illiquid assets could be transformed revolutionized the bond markets. Banks sitting on mortgage bonds, for example, realized that they could package them and sell them to the public, a process called "securitization," and make them tradable. This spawned the synthetic mortgage market (collateralized mortgage obligations, or CMOs), where mortgage principal payments were sold separately from the interest payments, and both those payments were sorted into tranches based on the likelihood that they would be repaid. (For more on CMOs, see chapter 9.) Car loans, credit card loans, home equity loans, manufactured house loans, church loans, and loans based on the sale of recordings by your favorite rock star later appeared. Instead of buying and selling bonds, traders began selling options to streams of income as a way to manage interest rate risk. Salomon Brothers engineered the first such swap between the World Bank and IBM in 1981. An interest rate swap involves an exchange between two parties of interest-rate exposures from floating to fixed rate or vice versa.

In one example of a swap, one party sells the flow of fixed-rate interest payments on the bonds they hold in exchange for payments tied to a short-term variable rate of interest. Each party to the exchange is protecting a different financial position. Instead of buying and selling the physical security, traders sell options and futures they created based on, or derived from, holdings of bonds, stocks, or commodities. Nonexistent in 1980, this business has become a trillion-dollar leveraged market that trades over the counter. In times of financial crisis, derivative trading can roil the bond markets in ways never seen before.

In the late 1990s, the Internet took off, opening up even more new possibilities affecting bonds. Although best known for all the new companies and stock that it spawned, the online revolution created possibilities for price transparency that did not exist before. Brokers started posting their offerings on Web sites; buyers had more up-to-date information on bond prices. In 2002, issuers electronically transmitted offering statements for newly issued bonds to national depositories; many also posted the statements on the Web for information transparency to support bond sales. Mutual funds took advantage of the medium by posting their prospectuses on their Web sites to provide easy access to buyers and reduce distribution costs. Information was available immediately in a quantity hitherto unimaginable. The effect was to make the sale and purchase of bonds quicker, easier, and simpler.

Inflation-indexed bonds, zero-coupon bonds, and many other bond types noted previously are described in detail in the rest of this book. So traumatic was the inflation of the 1970s that it led to the creation of these all-new bond types and ways to manage the risks associated with them. This book is going to tell you not only how to understand but also how to profit from all this creative turmoil. First, however, it's necessary to understand the basics of a bond—how it's created, issued, priced, and traded—and that's what the next chapter describes.

Chapter Notes

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