Understanding Bonds
"Understanding Bonds" is the fourth video in the Federal Reserve Bank of St. Louis series, "No-Frills Money Skills." The video host employs high-tech tools to foil Miss Information in her attempts to misguide investors. The video provides viewers with information about government bonds, corporate bonds, coupon and non-coupon bonds, and the potential risk and return of investments.
To provide students with online questions following each video, register your class through the Econ Lowdown Teacher Portal.
Learn more about the Q&A Resources for Teachers and Students »
Or, download the classroom discussion questions (pdf).
No-Frills Money Skills is a video series that covers a variety of personal finance topics. The brief videos use clear, simple language and graphic elements so that students can better visualize the personal finance content being presented. In the end, they will see how important these concepts are to their everyday lives.
This lesson received the 2015 Curriculum Silver Award from the National Association of Economic Educators. Read more about this and other awards.
Transcript
SCENE 1
Miss Information: Hi, good morning, welcome to Investco. How may I help you?
Prospective Client: I’m looking to purchase some bonds. I’ve been thinking about this for quite some time, and now I’m ready to invest.
Miss Information: Bonds? Are you serious? Don’t you know that they’re very risky investments? You’ll lose everything! But hey, who am I to judge? Let me get started on the paperwork and you’ll lose your money in no time.
Prospective Client: Gee, I had no idea! This isn’t exactly the response I was expecting, but thank you very much.
Miss Information: You’re very welcome. Be sure to tell all your friends. Have a nice day!
(Prospective client leaves. Miss Information smiles, pulls out a little mirror from her purse, fixes her lipstick, stands up from behind the desk, and casually walks away, just as the investment banker enters the scene.)
Investment Banker: Hey, what are you doing at my desk?
(Miss Information doesn’t stop to answer. She calmly exits the office.)
SCENE 2
(Next scene opens to a different investment office. A salesperson and customer are reviewing paperwork. Miss Information walks up to them, and situates herself next to the customer.)
Salesperson: (looking up) Excuse me, can I help you?
Miss Information: (laughing) I seriously doubt that, but I can help your customer here!
Customer: Really? How’s that?
Miss Information: Tell me … what are you buying?
Customer: Bonds.
Miss Information: Bonds? You like to live your financial life on the edge! You live dangerously, don’t you?
Customer: (confused) Wait … what?!
Miss Information: I know a much safer and more lucrative investment than bonds! Here, see for yourself. (She hands the customer a brochure.) Give me a call about it sometime. Have a nice day! Salesperson: (calling on speaker phone) Security, we have a situation here …
SCENE 3
(Miss Information calmly turns and heads toward the exit. The viewing angle shifts to a security camera view. She blows a kiss to a security camera, and exits the building. The security camera feed stops, rewinds, and we watch again as Miss Information blows the camera a kiss, and exits the building. This footage is being reviewed at CIA (or some agency) headquarters, where Agent One and Agent Two are briefing their Commander.)
SCENE 4
Agent 1: It’s been happening at locations all around the city. We have agents out canvasing the area searching for leads, but so far, they’ve come up short. (He gestures to the video screen.) We pulled this security footage from an investment broker earlier today.
Agent 2: (Again, gesturing to the video screen.) This is our perpetrator, and she appears to follow the same MO in every case. She contacts the prospective bond buyer, and tells him or her that he or she will lose everything they invest.
Agent 1: She goes on to suggest that she knows of safer, more-lucrative investment options, and she leaves behind a pamphlet, and instructs the would-be- -buyers to reconsider their purchase, and to consider investing with her instead.
Commander: A safer and more lucrative investment option than bonds? Clearly she doesn’t understand risk and potential reward … unless … she does understand risk and reward, and is trying to deceive people. This has to be the work of Miss Information. Devious!
Agent 2: Sir, with your permission, I’d like to double our man-power. We can bring in additional agents from surrounding boroughs, and I’ll authorize overtime for each and every …
Commander: (dismissively) No, no, that won’t be necessary. If my suspicion is correct, there’s only one man who can bring down Miss Information. (He pushes an intercom button.) Miss Moneynickel? I need you to locate …
Miss Moneynickel: (knowingly) I’ve already located him, sir, and we’re establishing contact now.
SCENE 5
Kris: When it comes to personal finance, there’s a lot to consider, and on this episode of No-Frills Money Skills, I’ll tell you everything there is to know about…
(Kris’ cell phone rings, only it’s not a normal cell phone. It’s a wrist-watch phone.)
Kris: Oops, sorry guys, I’ve got to take this.
SCENE 6
(We see a wide view of the studio. The director and video crew look perplexed and confused. The director signals to the cameraman to keep rolling. Kris pushes a button on his watch, and a holographic image of the Commander appears. Cameraman zooms into a tight shot of the hologram.)
SCENE 7
Commander: Bertelsen! Sorry to intrude on you like this but we have a situation and we need your help. Miss Information is wreaking havoc in the bond market. She’s spreading bad investment advice, and we need you to stop her.
Kris: Miss Information? Devious! Of course I’ll help. I’ll need you to send me everything you have on her, and I may need some material support.
Commander: I’ll get you anything you need. Stand by for further instructions.
(The hologram disappears.)
SCENE 8
Kris: Well, in light of recent developments, on today’s episode of No-Frills Money Skills, we’re going to learn about investing in bonds, and we’ll try and take care of misinformation along the way. A bond is much like a loan. It is a debt instrument, like an IOU. When you buy a bond, you are lending money to a government or corporation. For example, a bond issuer may use your money to fund a project, and, in return, pay you interest. Interest is the price of using someone else’s money. Bond prices move opposite the market interest rate. For example, suppose the yield on other investments rises relative to bonds. Bond holders may want to sell their bonds to get higher yields elsewhere. To attract buyers, bond prices will come down. This, in effect, increases the yield on bonds.
All levels of government issue bonds, and so do corporations.
Often, when people use the term bond, they are including other debt instruments as well. Just remember that debt instruments like U.S. government-issued Treasury Bills and Treasury Notes are usually shorter-term assets than bonds. In fact, corporations issue bonds that may take up to 30 years to mature—when the investor is paid the last interest payment and initial dollar investment.
One way in which bonds vary is whether they are coupon or non-coupon bonds.
Investors purchase newly issued coupon bonds at a dollar amount called the face or par value. The investor receives interest payments for a set time--–usually semi-annually or annually–until the bond matures. At the end of the term, the investor receives the initial investment back with the final interest payment, assuming the bond issuer has the funds. Many bondholders use the interest payments as income, for example, in retirement.
Zero-coupon bonds, are sold at a price lower than their face value because the buyers receive all of their return or interest when the bond matures. For example, one might buy a $600 bond with the understanding that it will be worth $1,000, say 10 years in the future. In the bond market, bond prices change with market-interest rates, investor’s preferences for asset types, and creditworthiness in the company issuing the bond.
Bonds, like U.S. Treasury Series I and E/EE Bonds, allow investors to make purchases right from their paycheck or online. They offer a great opportunity to save for retirement or for college. These low-risk bonds are available in denominations from $25 or more, to the penny. You could buy a bond for, say, $37.50. Other Treasury Securities are available starting at $100 and can be purchased in $100-dollar increments.
There are various features of Treasury securities to consider. For example, Treasury Inflation-Protected Securities or TIPS, is a type of bond that provides protection from inflation. If inflation rises, the principal of the bond is adjusted upward and vice versa. The semiannual interest rate is applied to the adjusted principal, helping the asset maintain its value. In many cases, there are tax benefits if the money is used for educational purposes.
If two bonds, identical in every way, were offered by different issuers; any difference in the interest paid on the bonds would reflect the risk that the issuer might default on the bonds—that is fail to repay the initial investment. If the government or company issuing the bond has strong credit and assets to back up the bonds they issue, there is little risk. If the issuer doesn’t have strong credit or assets, the risk of default—not paying the money back—is higher. Therefore, the coupon and bond price are determined, in large part, by risk.
C’mon. I know where we can learn even more about risk and potential reward.
SCENE 9
(Kris walks to the back wall and pushes a secret button, revealing a hidden panel which opens to reveal a secret spy lab. Kris enters the lab and initiates the Risk and Reward video, which appears as a three-dimensional, holographic image.)
SCENE 10
Risk and Reward Video: It is important to have an investment plan and understand risk before buying any financial instrument. Investors face different types of risk, but risk is basically the uncertainty that an investment will gain, or even retain, value. Generally, the higher the risk of loss of principal for an investment, the greater the potential reward, and conversely, the lower the risk of loss of principal for an investment, the lower the potential reward. A risk pyramid gives a general idea of how investments compare to one another.
Take a look at the various investment options on the pyramid to see the relationship between risk and potential reward.
At the top of the pyramid, with the highest risk and highest potential for return, are commodities, followed by antiques and collectibles, real estate, stocks, mutual funds, corporate bonds, Treasury securities or government bonds, certificates of deposit, savings accounts, and at the bottom of the pyramid, with the lowest risk and lowest potential for return, are cash and checking accounts.
Secure investments, like FDIC-insured savings and checking accounts do not offer a high potential for reward because they are essentially free of risk. At the other extreme, you find commodities such as oil, gold, or livestock. The prices of commodities are more volatile—that is they change frequently. So, the potential for risk of loss of principal is high for commodities, but the potential for return is also high.
Kris: As you can see, bonds are among the safest investments on the pyramid. Miss Information definitely needs to get her facts straight.
(A video phone in the spy lab becomes active, and the Commander addresses Kris.)
Commander: Bertelsen! The documents you requested are being transmitted now. You’ll have ‘em in just a few moments.
Kris: Got ‘em!
Commander: I’m sure you’re aware of the gravity of this situation. Keep me informed of your progress.
(A slew of documents appear on a very futuristic, heads-up display—a full dossier on Miss Information. Kris begins reviewing. We see snippets of security footage, with Miss Information telling people they’d lose everything if they bought bonds, and saying that she knew of safer, more lucrative investment options than bonds.)
Kris: (voiceover, as if in thought) Lose everything? Safer and more lucrative than bonds? What is she up to?
SCENE 11
(An alert sounds as Kris is reviewing documents.)
Kris: What’s this?
Computer Voice: Suspect has been located. Transmitting coordinates now.
Kris: Gotcha! Time to shut down Miss Information for good.
SCENE 12
(Cut to press conference, where Miss Information is addressing a group of investors.)
Miss Information: I have been trying to get people’s attention about the folly of investing in bonds and it has worked marvelously in many cases so far……Today, I am here to unveil my very own investment company and take deposits from investors of $1,000 per share. Get out your mobile banking devices; you won’t want to miss out on this opportunity. My company will be safer and more lucrative than bonds; and, from a practical standpoint…….
Investor 1: (Interrupting Miss Information) What does your company provide?
Investor 2: What is the risk that you won’t be able to pay back the investors? You said safer AND more lucrative than bonds. I don’t think that’s possible.
Investor 3: You’re information doesn’t seem to add up. Have you ever seem a risk pyramid?
Miss Information: Well, of course I’ve seen….a risk pyram…
(Kris bursts into the room.)
Bond: Stop right there Miss Information! These people have heard enough of your bad advice and your ill-conceived scheme. You haven’t even completed the initial paperwork to open an investment company. This ends now!
Miss Information: End? My dear, this is only the beginning!
(Without warning, Miss Information activates her rocket boots, and flies away.)
Kris: (walking to center stage) Well, we foiled Miss Information’s plans for today, but we didn’t put her away for good, and something tells me she’ll back. Remember, the best defense against misinformation is information; and, the more you know about the risks and potential rewards of investing, the more informed and safer you’ll be. I’m Kris Bertelsen, and I’ll see you next time.
---
If you have difficulty accessing this content due to a disability, please contact us at 314-444-4662 or economiceducation@stls.frb.org.
