The Ascent of Money - Part 2
In part 1 of this series, titled Dreams of Avarice, Ferguson took us on a journey (both back in time an geographically) to where money originated, where the practices of lending money began, and where the practice of lending money grew from small-scale operations to the larger-scale business of banking.
In this part, Ferguson explains how bond markets work and describes the events that led to the origination of bonds and the bond market, which were the next financial innovations (after the invention of money and the practice of money-lending) that changed the world.
Bonds had a tremendous impact on history, as they gave countries the means by which to raise funds in order to carry out wars. It gave citizens of a nation, and investors alike, the ability to have a financial stake in the outcome of wars. Today, bonds are still the means by which countries, companies, states, and cities raise the money they need to fund projects and improvements.
The Ascent of Money (Part 2): Human Bondage
As we did with the last part of this series, there are a couple of things we would like to emphasize about this part and how it applies to your personal finances.
What Are Bonds
First, you should have a basic understanding of what bonds are and how they work. A bond is essentially an instrument of debt in which:
The buyer pays a certain amount of money to the issuer of the bond.
The issuer of the bond promises to pay all that money back after a certain amount of time (ex. 10 years).
The issuer also pays a certain amount of money (ex. representing 6% interest) every so often (ex. every year) to the buyer of the bond as an incentive for lending them the money.
Risks Associated With Bonds
In addition to understanding what bonds are, it is important to understand what risks are associated with investing in bonds.
As mentioned in the video, one major risk of investing in bonds is inflation. The higher inflation is, the less money is worth. The less money is worth, the less the fixed amount of money you’re getting back every year is worth and the less the amount you lent them that you are going to eventually get back will be worth. It won’t buy a much as it did when you gave it to them.
Another major risk associated with investing in bonds is interest rates. Think of this as bonds competing with other bonds. If you bought someone’s 10 year bond at 6%, and now there are other 10 year bonds out there paying 8%, you’re going to feel like you’re being cheated out of 2%.
Because of this, you would feel like selling your bond and buying a newer, higher-paying bond. However, you would have to sell that bond for less than face value because that’s the only way someone else would buy it, given that there are better-paying bonds out there. This is a very simple example of how the bond market functions.
Finally, there is the risk that the issuer you bought the bond from (and essentially lent money to) will default and you won’t get your money back. The interest rate on bonds is usually representative of the default risk involved, so the safer your money is, the less return you will probably receive on your investment.
Go to the next post in the series - The Ascent of Money (Part 3) - Blowing Bubbles.
Learn more about Niall Ferguson at his website - NiallFerguson.com.
Buy Niall Ferguson’s book - The Ascent of Money: A Financial History of the World.