What Bonds Are and How They Work

Almost nobody asks the obvious question. Where does the money actually come from?

The answer, almost every single time, is not from tax revenue sitting in a government bank account. Governments spend more than they collect in taxes, especially during recessions and crises when spending needs to go up at exactly the moment that tax revenues are falling. They need to borrow the difference.

But governments do not walk into a bank and apply for a loan. They issue a piece of paper that says: lend me money today, I will pay you a fixed rate of interest every year, and at the end of a specific period I will return every dollar you lent me. That piece of paper is a bond. And the market where these pieces of paper are bought and sold is the largest financial market in the world, larger than the stock market, larger than the forex market, larger than everything else combined.

When the US government issues a bond with a face value of $1,000, a coupon of 4%, and a maturity of 10 years, it is saying exactly this. Lend us $1,000 today. We will pay you $40 every year for ten years. At the end of ten years we will give you your $1,000 back.

If you are a pension fund that needs to match known future liabilities, paying retirement income to thousands of teachers in fifteen years, this is extraordinarily attractive. You know exactly what you are getting, exactly when you are getting it, and from one of the most creditworthy borrowers on earth. The certainty is the value.

The face value is the amount returned at maturity. The coupon is the annual interest rate, fixed forever at the time of issuance. The maturity date is when the loan ends. These three things define every bond ever issued.

But those investors do not have to hold their bonds until maturity. They can sell them to other investors in the secondary market. This is where bonds trade every day between institutions. It is where prices fluctuate. It is where yields are discovered.

The secondary market for US Treasury bonds is the deepest, most liquid financial market on earth. Trillions of dollars change hands every single day. And the prices and yields that emerge from this daily trading are the single most important set of signals in all of global finance, influencing mortgage rates, corporate borrowing costs, stock valuations, currency movements, and the decisions of every central bank on the planet.

The answer is not about maximising returns. It is about certainty.

A pension fund managing retirement savings for half a million teachers knows exactly what it owes those teachers over the next thirty years. It cannot afford to have that money in assets that might fall 40% in a bad year. It needs assets where it knows with near certainty what it will receive and when.

A bond from a stable government offers exactly this. The US government has never defaulted on its debt in the modern era. When you buy a 10-year Treasury bond you know with as close to certainty as anything in finance offers that you will receive $40 per $1,000 invested every year for ten years and your $1,000 back at the end.

Government debt with a maturity of two to ten years is called a Treasury note. Pays regular coupons every six months. Government debt with a maturity of more than ten years is called a Treasury bond. Also pays regular coupons.

The collective name for all of this is Treasuries. When traders talk about Treasury yields, about the bond market selling off, about yields spiking, they are almost always referring to notes and bonds, particularly the benchmark 10-year Treasury note.

In the UK, government bonds are called Gilts. In Germany they are called Bunds. In Japan they are called JGBs. Different names, identical structure. Each is the benchmark for interest rates in its home market.