But not the kinky kind... Ok, maybe the kinky kind, it depends on what you're into. I'm not gonna judge. What we're talking about today are bonds, as in the financial instrument.

So we'll start with a definition: what is a bond? In its simplest form, it's a promise of repayment. A bond issued with, for example, a face value of $1000 and a maturity date of January 1st, 2030, can be redeemed for $1000 in cash on or after January 1st, 2030. (There are other forms of bonds where the face value and maturity date have a different relationship with how much money you will receive and when you will receive it, but as we go along I think it'll become clear why we're focusing on the simplest type of bond, and for the most part the other types of bonds can be reinterpreted as this simple type with some basic mathematical manipulation).

Now suppose I offer to sell you a $1000 bond that matures in 2030. You might look at the $1000 sitting in your pocket and wonder why you would ever want to trade it for this promise of getting $1000 sometime in the future; after all, you could just hold onto that $1000 as cash and, providing you don't spend or lose it in the meantime, you'll be guaranteed to still have it in 2030. So if I want to sell you this bond, I'll need to sweeten the deal somehow: instead of offering to sell you the bond at $1000, I decide that I'll take $900 of your money today in exchange for giving you $1000 in 2030. This is known as the "discount". Of course it might be that $900 is still too high for you to be interested in the deal, since perhaps you have other things you could spend that $900 on which would give you better returns than $1000 in 2030, but for the sake of simplicity let's say that you find the deal appealing.

Now let's consider the flip side: why would I ever want to promise to give you $1000 in 2030 in exchange for $900 now? Well that all depends on what I can do with that $900. Suppose, for example, that I'm running a small business, and I need to buy a piece of equipment to help me produce my products. I've done an analysis of how this equipment will help my production and determined that I can make an extra $250 per year with it. But I don't have that $900 in my pocket right now to help me buy the equipment, and so I'm in a bit of a chicken-and-egg scenario: I could make enough money to buy the equipment if I had it, but I need the money to buy the equipment before I make it.

So now the deal starts to make more sense: I issue you a $1000 bond for $900 and put that that $900 towards buying the equipment. Over the next 5 years I make $1250 using that equipment and then when 2030 rolls around I repay you the $1000 face value of the bond. You end up $100 richer, I end up $250 richer, and everyone is happy.

But now let's consider a twist: suppose that in less than 5 years from now you find some other opportunity to invest your money in. But you don't have your money just yet, all you have is a bond that will mature in 2030. You could pass on the opportunity and just wait for the bond to mature to get your $1000, but you'll miss out on that other opportunity and you're pretty sure that even if you sold the bond for less than $1000 right now, if you could jump on that new investment you'd make back more than what you'd give up selling the bond at a discount. This is where the "secondary market" comes in.

The secondary market is where investors can sell the bonds that they hold to other investors, and the price is determined by what each investor finds to be mutually agreeable. Since NicoCorp is doing fairly well and I'm raking in the cash with my new equipment, there's no particular reason to expect that I'll fail to repay the bond at maturity, and there's only a few years left until that happens. So it's almost as good as cash, and you shop it around and sell it for $975, still making a $75 profit on your initial investment, while also freeing up the $900 you initially put in, so that now you can jump on that other opportunity.

So at this point you might be wondering how people figure out what price a bond should sell for, and this is determined by two factors: the yield and the risk. The yield can be directly calculated, and it's the difference between the sale price and the face value, expressed in terms equivalent to an annual compound interest rate. So as the sale price of a bond goes down relative to its face value, the equivalent compounded interest you'd earn on it at maturity rises. Conversely, if the sale price goes up, the equivalent compounded interest falls; essentially your money isn't going to grow as much. Expressing the yield this way allows investors to combine the time-to-maturity and the discount into one number that expresses the meaningful combination of both, so that two different bonds can be directly compared.

So if we suppose that one bond has a 6% yield and another bond has a 3% yield, an investor would, risk aside, be better off buying the bond with the 6% yield. So why would any investor pick the 3% bond instead? Well, because they don't put risk aside.

Remember that a bond is only a promise, and until it's redeemed it's only really worth the paper it's printed on. If the issuing entity defaults on its obligations, then you might receive nothing at all in return for your investment, or perhaps just a small fraction of it, and you'll have no recourse to recover the rest. So if there's a high risk of default (or conditions equivalent to a default, such as high inflation devaluing the currency that the bond was issued in) then an investor would demand a higher yield to make up for it. Or, if that investor has a low risk tolerance, like for example if they're a senior citizen who doesn't have a lot of years left to make up for some short term losses, then they might want to opt for the safer, lower yield investment regardless of how much potential extra returns they could get by assuming more risk.

Now this risk factor is a characteristic of the issuing entity, so let's take a closer look at why those issuing entities (businesses, governments, etc) issue bonds, and what their debt load and budget deficits mean.

In our example above, we only really looked at a single transaction buried inside of NicoCorp's budget. I needed to buy one machine, I issued one bond, and I bought the machine. Let's look at the whole picture instead: NicoCorp normally makes $10,000 per year in revenue and has $9,900 of expenses, for a healthy surplus of $100 in profit. However buying that machine, which was $1000, drove up the expenses to $10,900 on the same $10,000 revenue (remember, this is just the snapshot at the start, I haven't installed the machine yet and got it up and running), leaving me with a $900 budget deficit that I have to somehow cover. But luckily I sold you the $1000 bond for $900, which means that I just barely broke even for the year in terms of cash flow, but increased my debt load by $900, and as we already saw, that $900 of debt is easily manageable with the increased revenue that the upgrade will bring in.

So thinking about this, you might wonder: why stop at just that one $1000 bond? What if I sold a few more bonds and bought even more equipment? Could I make even more money? The answer is: maybe!

Let's look at a few limiting factors: perhaps I might saturate my market and start to run out of people to sell things to. Well, that would mean that each extra piece of equipment I buy would bring in a smaller amount of revenue, and eventually I'd get to a point where that revenue wouldn't be sufficient to pay off the bonds at the discount I could sell them for. But also, as my debt load increases, investors might start to get nervous about the amount of risk they're taking on by buying bonds from me, and so they'll start to demand higher yields which will also make it harder for me to balance that against the increased revenue I'd expect to make. And that's not to mention that there's my own risk tolerance: I can't necessarily predict what the future might actually hold, so my projections of how much revenue I'll earn for each additional piece of equipment might not be what I expect, and I might want to reduce my risk exposure and opt to grow my business more slowly.

So there's a risk to issuing too many bonds and taking on too much debt, and that's a risk that most people are familiar with. But surprisingly, there's also a risk when you take on too little debt!

Let's suppose that the yields in the bond market are way down and confidence in my business is high: there's a lot of opportunity for me to make money, but tapping into that opportunity is going to require spending money to make money. If I just sit on my hands, that opportunity will pass me by, and the easy money I could have made will just slip away; my inaction will have cost me those potential future profits. But even worse, suppose that my balance sheet is already slipping into the negative because I steadfastly refuse to make capital upgrades: I'll have to issue bonds anyway to keep the cashflow balanced, but since I'm not issuing enough bonds to make those capital investments in buying new machinery, I won't be seeing any increased profits that I'd need to make in order to pay back those bonds. I'd just be in a downward spiral toward bankruptcy because I didn't have enough debt! How counterintuitive!

So to restate the question: what's the right amount of debt to carry? What's the right level of budget deficit to have? As we've established, the answer is definitely "it's complicated" and it's very rarely the "zero" that some people tend to gravitate towards. Does it make sense to compare the size of my debt to my annual revenue? A ratio like that can give you some sense of scale, but there's no magic numbers. Similarly, what about comparing my budget deficit to my annual revenue? Is there a magic number there? Again, not really.

And of course, if I'm both carrying and issuing debt, does that mean I'm taking out new loans to pay off old loans? In a way, yes, but again if there are investments I could be making in NicoCorp that will pay a better risk-adjusted rate of return than the cost of issuing new debt, then I'd be a fool for not doing it; I'd be leaving money on the table.

Now all this is really a long winded way of saying that when people talk about the size of the national debt, or the budget deficit, and throw around numbers like debt-per-capita, debt-to-gdp, and so on and so forth, you really need to do your homework to make sure that you're not getting mislead. There isn't a "right" value for any of these numbers, and there isn't a moral imperative to reduce either of them to zero (so don't be fooled by "balanced budget" initiatives). What is imperative, though, is to ensure that the investments that are being made are sound and that the revenue being raised is being done effectively and efficiently. Unfortunately, you'll need to do more than just look at headline numbers to understand how good a job is being done on those fronts, but now that you understand bonds you'll be on a much better footing for it!