How do bonds work?
Before we get into the details of why interest rates affect bonds, let's look at how bonds work.
A bond is an instrument that investors hold as a sort of IOU. The buyer pays for the promise of interest rate payments and the return of his capital at the agreed-upon times. A government or company issues bonds to get capital without raising taxes or diluting equity, respectively, and buyers buy bonds for their portfolios for several reasons. You can purchase bonds via online stock brokers, as our recommended ones to use are:
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There are six parts to a bond that investors must consider:
- Issuer — Who is selling the bond. This can be a government or a company.
- Principal — The amount to be paid for the bond when it is issued.
- Maturity Date — When the issuer of the bond must pay back the investor. This varies widely, from months to years. Some governments have even issued 100-year bonds!
- Face Value — The face value of a bond is how much it will be worth upon maturing. The issuer uses this number to calculate interest payments.
- Coupon Rate — The interest rate of the bond, as a percent of the principle. A $1,000 bond with a coupon rate of 5% pays $50 in interest each year.
- Coupon Dates — The prearranged dates when the interest will be paid to investors. This can be at any time, but the most popular interval is semiannual.
The relationship between bond prices and interest rates
While bonds are a key part of a government's budget and how companies raise cash, people don't realize that a bond's price can change, and it can trade at a premium or a discount to its original face value.
The life of a bond can follow many twists and turns in price on the way to maturity. First, it is issued at an agreed-upon price and bond interest rate, normally to large investors who have signed up to buy these batches of bonds ahead of time.
These investors can hold bonds until maturity while collecting interest payments. But what if they want to sell them before maturity? Investors can sell them to other investors on a bond market called the “secondary market.” Anyone can access this market through a broker.
In the secondary market, the prices of bonds move freely with supply and demand.
As we will see, the reasons for these price changes are numerous, but the biggest reason is interest rates.
Bond interest rates
The central bank sets national interest rates to regulate inflation and money supply in an economy. Specifically, central banks move interest rates to stimulate or cool down the economy.
Interest rates dictate a lot of our lives:
- The interest rate of your checking account is dictated by the national interest rate.
- This rate is often considered the risk-free rate, as you can pull your money at any time, and it is safeguarded by the government in case your bank goes under.
- But when you invest in stocks, you expect a higher rate of return because there is a chance that the value of the stocks goes down.
Bonds work by the same logic. If you are going to lock up your money in a bond, the bond interest rate would have to be higher than what you get from your checking or savings account; otherwise, no one would ever invest in bonds.
For that reason, whenever interest rates go up, new bonds being issued raise their interest rate to match it. When interest rates go down, governments and corporations capitalize on the fact that they no longer have to pay the same amount of interest. So they issue bonds with lower bond interest rates.
Bond prices and interest rates on the secondary market
Now, let's say you are currently a bondholder with a 3% bond interest rate. The central bank raises interest rates causing the companies to issue new bonds with a 4% interest rate. In this case, investors want the new yield.
In this case, if you want to sell your 3% bond, you need to sell your bond for a lower price, so the new buyer will still receive the 4% that new bonds offer. As mentioned above, the price of bonds is inversely related to the interest rate being offered.
All of this impacts the bond yield. Financial website quote this number next to bonds they list. The bond yield (a percentage) tells investors how much they can make by holding the bond. It sums up the relationship between bond price and interest rate.
The formula for bond yield is simple:
Current Yield = Annual Payment of Bond / Market Price of Bond
As we see from the formula, the bond prices are inversely correlated to bond yields. When one moves up, the other always moves down.
Besides interest rates, the other major factor that impacts this relationship is a risk. Investors expect a higher yield to compensate them for taking on a higher risk.
For example, the bond of a company that may go bankrupt within the next year will have a massive discount to its original issued price and yield in the double digits. This may entice some investors willing to take on the risk in order to enjoy the large total return, both from the interest and from the chance of the bond price appreciating in value.
Other factors that impact bond prices
Supply and demand can also affect bond prices and yield. Generally, when investors are fearful, they get out of stocks and buy bonds in order to safeguard their money. This increased demand pushes up the prices of bonds on the secondary market and, in turn, decreases their yield.
We saw a perfect example of this in March 2020. Bond prices rose when the markets crashed due to COVID-19 fears. It is important to remember that market prices are constantly adjusting.
Should you invest in bonds?
Bonds are less risky than stocks and provide a steady stream of income. For these reasons, bonds have a place in most portfolios, either as a permanent percentage of the portfolio or as a tactical allocation when certain market conditions make them more attractive than stocks.
Mutual funds are another way to invest in bonds, and together with Exchange-traded funds (ETFs) makes investing in bonds easy. ETFs are often the most straightforward option for individual investors, as it gives investors a liquid way of investing in a large basket of bonds and further lowers the risks. Public.com makes buying and selling stocks and ETFs free and easy and is our recommended broker to start trading.
Bonds may seem complex at first, but once you understand them better and look at the benefits, it's clear that every investor should have some bonds in their long-term investing portfolio.