One of the fallacies that seems to plague those who are wholly unfamiliar with capital markets, economics, or even basic finance, is the idea that certain productive asset classes - bonds, in particular - are non-productive.  For anyone with any understanding of the mechanics, it's such an unbelievable, almost nonsensical, display of naïveté, it's hard take it seriously.  That is, I suspect, why it is hardly addressed or corrected.


 It's a common mistake and once you are aware of it, it's likely you'll encounter it everywhere.

Those who suffer from this fallacy have no idea that bonds are among the most productive assets not only in the world, but throughout all of human history, stretching back as a prime form of capital sourcing for thousands upon thousands of years as they simultaneously build nations and generate passive income for the owners.  A portfolio stuffed with bonds is not dead money, just sitting there.  Quite the opposite!  It doesn't matter if we are talking about savings bonds or debentures issued by a local factory to expand production.

It is on the back of bonds that schools, hospitals, roads, railroads, bridges, dams, power plants, telecom systems, and sewage management facilities are built.  The Allied Powers were able to defeat Hitler in World War II due in no small part to the money raised by bonds, which paid for guns, ammunition, medical supplies, planes, housing, and salaries for millions of soldiers.

 They were so necessary to the war effort that a "buy war bonds" propaganda campaign was unleashed on the population, encouraging them to buy as many war bonds as they could possibly afford to support the effort.  Bonds can help expand local police and fire capabilities.  Bonds can fund scientific research at rock-bottom rates to cure for disease and lessen human suffering.  Bonds mobilize large numbers of citizens to build projects through institutions and governments that are beyond the capabilities of any particular person.  It can be said that investing in bonds is the financial foundation of civilization itself.  That is the reason the bond market utterly dwarfs the stock market in size even though you're exponentially more likely to hear about the Dow Jones Industrial Average on the evening news.

To understand how bonds are productive, you need to understand what a bond is; the very nature of the thing itself.

To Understand How Bond Investments Are Productive, You Must Understand What a Bond Is

The word "bond" is used to describe a legal contract in which one person (the investor) loans his or her savings to a borrower (the bond issuer).  This contract is governed by a document called the bond indenture, which spells out when the money will be repaid, how the money will be repaid, what happens if the money isn't repaid, what the borrower plans on doing with the money, what protections are in place to make sure the borrower can't jeopardize the repayment, and the rate of interest that will be paid to the lender in exchange for "renting" his or her savings.  All sorts of entities issue bonds, including municipalities (cities, towns, counties, states), sovereign governments, non-profit institutions, and for-profit corporations.

Imagine you live in a small farm town that has grown considerably over the past few years.  The local school board concludes it is time to build a new school.  The project will cost $3,000,000.  The town doesn't have that kind of spare money sitting around from property taxes (nor would it be a good thing if it did as it inevitably would serve as a source of temptation for some politician down the road to raid it for his or her own personal pet project or fringe benefits).  It would take years to save the money from existing revenue streams, which is not acceptable since the children need to be educated today.  After talking about it, the school board decides the best, cheapest, most efficient way to get the new school built is to issue bonds.

The school board goes to the local citizens and asks them to vote on a new law that will allow them to issue $3,000,000 in bonds, raising cash to buy the real estate, hire the architects, pay the construction crew, reroute the roads in the vicinity, purchase the new computer equipment, buy new desks, install new pencil sharpeners, and the host of other things necessary to accomplish the task.  The law stipulates that the bonds will be repaid over 20 years and that the money to cover the repayment will come from a new sales tax that will apply to all purchases made in town at a rate of 1%.

Meanwhile, Farmer Bob is 50 years old and lives on the outskirts of town.  He makes his living growing corn, soy beans, and other crops on several thousands acres of land his family has worked for generations.  He likes to save money - being a farmer will do that to a man because you realize how one bad run of luck can take you down if you don't have stored provisions - and sees that the local school children need a new building.  He wants to help.  Instead of investing that money in stocks, private businesses, or real estate, where he could earn a much higher compound annual growth rate, he decides to lend it to the school board.  He takes $100,000 out of his savings - money he has put aside year after year by living below his means - and buys some of the new school bonds.  He writes a check to the underwriter handling the transaction (or, rather, his broker takes care of the paperwork) and is given a bond certificate in exchange that serves as a receipt; proof that the school board has his money, is using it, and will pay him rent on his savings (interest) until the day it has returned all of his cash.

To help facilitate the transaction and reward the citizens who helped fund this vital part of the local community, the Federal and state governments agree not to tax the interest Farmer Bob and the other investors earn on the loan.  This has the effect of 1.) thanking them for funding the project instead of putting it to work in higher returning asset classes, and 2.) keeping costs down for the school board, which can advertise the tax-free status and pay a lower interest rate.  This is such a powerful motivator, there are some investors who will only invest in tax-free municipal bonds.

The project goes off without a hitch and the school board raises the entire $3,000,000.  The bidding process results in the bonds being set at a 4% fixed rate for 20 years.  Had the school board borrowed from a bank, it would have cost the citizens much more money that now, instead, can be used for employee pensions, additional projects, or tax cuts depending on the values of the population.  Additionally, not only would a bank have charged a higher interest rate, banks wouldn't tolerate an interest-only loan at a fixed rate of interest stretched out for two decades.  Rather, it would have demanded some principal reduction along the way, meaning much higher payments.

An Overview of What Has Happened and How the Bond Is Being Productively Used by Society

What, specifically, has happened in our illustration?  Though this is a bit of an oversimplification, the big points are:

• Farmer Bob and his fellow citizens have handed over $3,000,000 of their savings to the school board in exchange for a receipt (bond certificate) and a legally enforceable promise the money will be returned at some point in the future, along with interest paid at a fixed rate over that time, all on a predetermined schedule.
• The school board has taken that $3,000,000 and spent it, putting it back into the economy.  From the construction materials, the construction workers, the electricians, the employees of the business that manufactures the desks, the light bulbs that need to be installed, all of it is expended and, within a very short amount of time, is out there in the hands of individual citizens who helped construct the new school.
• Every time someone goes into a local grocery store, gas station, restaurant, or shop, a special 1% sales tax is added to their purchase.  That money is put into a disbursement account by the local government so the interest checks on the bonds can be paid, which amount to $120,000 per year.  Any surplus is set aside into a reserve designed to pay off the entire bond issue at the 20 year maturity date, when the whole $3,000,000 has to be returned to the savers who put up their own cash to build the school.

When you understand this, you understand that the safe deposit box full of bond certificates Farmer Bob has down at the local bank, specifically the $100,000 in school bonds that pay him $4,000 per year for the next twenty years, is not non-productive capital nor is it dead money withdrawn from society the same way a gold coin is.  It's already been spent.  That money is back in the community and circulating from the construction process of building the new school.  The school board hired the architect, who then had to pay the local dentist for braces for his daughter.  The dentist went to the grocery store to buy food.  The grocery store bought some of its produce from the local farmer.  The farmer then needed a new tractor.  The tractor dealer donated the profit to the local church.  The local church needed materials for a Christmas pageant, buying fabric from the local fabric store.  Ad infinitum.  Those bond certificates are tangible tokens of legal contracts entitling him to get his savings back over time, with interest, while his savings are out there being used productively by the civilization.  Every morning, when school children show up to class, his money is being productive.  Every day, all day, the money out there in circulation keeps flowing through the economy, generating more sales and income tax as it changes hands.

When another investor comes along and offers to buy Farmer Bob's bond certificates, all he or she is doing is offering a pile of cash to swap places with Farmer Bob.  He or she is offering to buy the promises; the legal contracts that facilitated this huge improvement in the educational quality of the local town.  They are offering to pay off Farmer Bob early so he can get his savings back in the event he needs them, taking his place on the school board's roster of bond holders.  Even the school board benefits from this because the flexibility to sell the bonds to other savers adds liquidity to Farmer Bob, meaning he accepted a lower interest rate than he otherwise would have accepted.  That meant it (the school board) enjoyed an even cheaper interest rate than would have been possible.  It's all connected.

Why the Fallacy of Bonds Being Non-Productive Assets Persists Among the Financially Illiterate

At its core, this notion of bonds being dead money comes down to a little bit of knowledge being dangerous.  The people who assert it only know enough about economics and finance to see the symbol of the bond - the piece of paper and interest checks - not the reality of what the underlying money is doing; that it has already been spent, is circulating throughout the economy, and resulted in better infrastructure with a building that is now regularly used to educate the younger members of the population.