Bond Markets - Chains of IOUs

Credit: http://www.learnbonds.com/how-big-is-the-bond-market/

I did not even know what a bond market was till recently. Essentially, it is the market for all IOUs issued by a variety of market participants. The market is composed of issuers, intermediaries, and investors. All debt is eventually financed and priced in these markets. These includes :

1. Credit Card Debt
2. Auto Loans
3. Personal Line-of-Credits
4. Mortgages
5. Municipal bonds
6. Corporate Bonds
7. Sovereign Bonds like US treasury.

An issuer is the person who wants to borrow. In return for the money borrowed, the issues of the 'bond' promises a sequence of cash flows. The cash flows may be structured differently from issue to issue, but they all have one thing in common. The issuer will pay some premium for the money lent. This cost of borrowing is expressed as an interest rate. The interest rate is the lender's incentive to part with his money.  The lender is the investor. The intermediary is an institution that does one of several things:

1. Arranges a meeting of the issuer and the investor.
2. Restructures debt in order to intermediate for various risks.
3. Services the debt. ie. initiates, collects, follows-up etc on the loan.
4. In some cases, the intermediary will also act as an investor.

The bond aka "A promise to pay" is subject to various risks:

1. Credit Risk: The risk that the issuer becomes insolvent and cannot repay.
2. Inflation Risk: Macro-Economic conditions make the repayments less valuable.
3. Interest Risk: Future interest rates rise, making existing bonds less valuable.
4. Exchange Rate Risk: For international transactions, the changing currency rates may make the repayments less valuable.
5. Timing risk: The issuer prepays the loan, leaving the investor with a pile of cash that is no longer generating interest.

I attached the picture to record for myself the rise in dominance of mortgage backed securities over time, the turnaround after the sub-prime mortgage crisis is evident with the downward dip around 2008.

Amortization Schedules of Mortgage.

Recently, Tina and I,  became home owners, and one of the experiences in that journey was the act of taking on debt. It was the second largest financial contract I have ever entered into. The first being my employment contract. When I was trying to figure out how the interest rates advertised were converted into my monthly payments, I realized that I really had no clue. Its three years now, and I think I finally get it.

Thanks to Prof. Schiller and Prof Andrew Lo, I believe I understand the concept of amortization. Their courses are available here:


YouTube: Financial Markets (2011) with Robert Shiller
Finance Theory I: Prof Andrew Lo

One of the aspects of the amortization schedule led me to the impression that the contract was in favor of the banks. Now in all reality, all contracts will typically favor the lender, but this specific aspect that bothered me was the fact that monthly payments in the early days of repayment almost entirely go towards interest payments. And I wondered to myself if this is a somewhat arbitrary decision of the banks. Was it unfair?

Now I see that the interest I was paying was simply the pro-rated interest that I owed on my outstanding loan till that point in time.
Lets say, I borrowed 100 USD @ 10% APR.  So at the end of month 1, I owed to my creditors.

Interest  = Principle * (Interest_APR/12) = 100 * (5%/12) = 0.4167 USD.

But lets say I had 5 dollars of available cash to repay.The bank takes the interest owed to them (0.4167 USD) and leaves me with 5 - 0.4167 = 4.5833 to repay my principal amount. Next month, I would be paying interest only on the the amount outstanding. Sounds fair enough to me.