The stock market gets all the love. Usually, when we think of investing, we think of that. But the global bond market is even bigger than the global stock market in size - $100 trillion to $85 trillion respectively.
Bonds - or fixed income, if you will - play an important role in your investments, even if your portfolio is all-stock, and it’s important to understand how they work.
You might have heard something like this: “bond prices and yields have an inverse relationship” or “as interest rates go up, bond prices go down”. What does that mean?
Think of a bond as a loan. You are lending someone (a company, a municipality, the US government, etc) some money with the agreement that they will pay you an agreed-upon interest rate and then return your original investment to you on a particular date.
When you buy the bond (lend the money), the interest rate will be set based on:
The prevailing risk-free interest rate at the time
The creditworthiness of the borrower
The terms of the bond: how long until it matures, or gets paid back
Any extra features the bond might have to make it more attractive to investors
The prevailing risk-free rate is usually understood to mean the 3-month US Treasury bill: it’s as close a proxy as we’ve got to represent your alternative choice if you wanted to be pretty much assured you won’t lose your money. As you recall from last year’s post about risk, risk-free means free of default risk - the US government can always just print more money, so you are guaranteed to get your initial investment back. But the rest of the risks (reinvestment, inflation, interest rate) are negligible for such a short amount of time, so that’s why we call it a proxy for the risk-free rate. There will be a prevailing interest rate for other things like different maturity government instruments, a 30-year fixed-rate mortgage, or 4-year auto loan: you can see various examples and how they change over time here.
From there, the interest rate on a bond offered by a company or a local government will increase depending on the next three bullet points. When the bond is initially offered, it will be at par value (usually $1,000 per bond) and have a stated interest, or coupon rate. That rate needs to be set at a number that will make it attractive to investors (everyone wants to earn a bigger stream of income) but remember that the borrowing organization needs to make the payments, so it can’t be too high or the borrower will have trouble meeting the obligation. That’s why it’s important for borrowers to understand the rest of the market and how attractive their offering will be. Once the bond is initially offered (it’s usually just large institutional investors buying at this point), the borrower gets the money to fund their operations or grow.
Let’s take an example of one ten-year bond of $1,000, with a coupon rate of 5%. Every year, the bond will pay $50 (5% of $1,000), and after 10 years the $1,000 is returned. The YIELD - the amount the bond actually returns on the initial investment - is also 5% at this point. The buyer and seller effectively agreed that 5% every year was an adequate amount to for the seller to compensate the buyer for the use of that $1,000 for 10 years, and the extra risk the buyer was taking on that the seller would default, their money would be worth less in 10 years due to inflation, and that interest rates would change in that time.
Then the bond is traded in the secondary market. Here is where things start to change. The coupon rate stated on the bond stays the same, however. If a bond is offered at 5%, it will continue to pay 5% of the par value. But the world doesn’t stand still, and as market conditions - mainly, the prevailing interest rate and the creditworthiness of the borrower - change, the bond price will change in reaction. In other words, the bondholder who is looking to trade the bond has to assess market conditions and how they’ve changed, and re-price the bond accordingly.
Let’s say it’s a year later, and the risk-free rate has increased by an entire percentage point, and the bond issuer - the company or organization paying the coupon - has had some negative press lately due to mismanagement. They would not be able to issue the same bond, now with a 9-year term, for the same rate. They would need to pay a higher rate to compensate investors for the higher perceived risk of lending them the money, as well as higher interest rates in general. So our bond, if issued today, would have to have a coupon of 7% instead of 5%.
So the bondholder, who currently owns the bond, wants to sell to take advantage of the better investment opportunities out there. But no one will buy a bond that is yielding only 5%, because any investor would demand a higher return. Well, you can get this bond to yield a higher return too, you just have to drop the price until you achieve the yield you want.
To get the yield to maturity (the total return if you hold the bond for the remaining 9 year term) to be the 7% that the market is requiring right now, you would have to sell it at $861.15 to make it attractive to investors - who, remember, can simply buy any bond on the market that fits their required yield. Note that these numbers are pretty exaggerated to illustrate the effects of a change - typically the moves won’t be so large.
And this works the opposite way too: if prevailing interest rates fall, and/or if the borrower’s fortunes have improved and they are seen as a safer bet, one of their bonds with a relatively high interest rate will become more valuable in the market and the bondholder can get more for their bond when they sell.
You can use this little tool to try out different combinations: change either of the two yellow-highlighted cells to see how it changes the yield (in green)
So this is why bond price and yield work inversely. The concept applies outside of the bond market as well (and in fact, most stocks themselves have yield, in the form of dividends - it works the same way). You can apply the principles to your own finances and what your own mortgage and loans are costing you, and even beyond your finances. Think of a garden: the amount of vegetables produced is the yield, regardless of how many seeds you plant or money you spend up front. Of course, everyone wants to maximize that yield while minimizing the input required. This isn’t so different.
And even if you don’t own bonds in your portfolio, this affects you - the companies whose stock you own will have to pay more or less in interest depending on how the rates change as they look to borrow more. This is why the stock market often declines when the Fed raises interest rates: because of the expectation that it will cost companies more to borrow to fund growth, and that will either cut into profits or negatively affect long-term growth potential.