Bond prices and yields are a core financial concept but, in our experience, can often cause much confusion. However, knowledge of how they operate is critical to understanding broader financial markets and monetary policy.

What are bonds?

Bonds are, in essence, an instrument through which an investor lends money to a borrower.

Effectively, through a bond, the investor is making a loan to an entity, which is typically a government or company. These entities then use the money from these loans to finance operations and investment projects.

The borrowing entity sells or “issues” the bond to the investor who buys them.

In exchange for the loan, the investor typically receives a fixed rate of interest which is called the “coupon” or “coupon rate.”

Like loans and mortgages, bonds have a date by which the original loan — the “principal” — to be repaid. This is commonly known as the “maturity date.”

If you think about it, this is effectively equivalent to obtaining a mortgage on your house, in reverse. In the case of bonds, though, you, the investor, play the role of the ‘bank.’

This is an oversimplification, but there are nuances with bonds that we will delve into.

What is the yield of a bond?

The “yield” on the bond is basically the rate of return that the investor receives for the price they bought the bond for.

So, say you purchased a bond from a company — CashStrapped & Co. — for $10,000, and it had a coupon of $500 per annum. In this case, your yield would be 5% calculated as follows:

Yield = $500 / $10,000 = 5%

Riskier bonds will tend to have higher yields to compensate the investor for the increased risk of default and vice versa. Again, this is similar to getting a mortgage, i.e., you can typically get a better rate if you have a good credit history, a large deposit, etc.

Government bonds (e.g., US Treasuries) are typically considered the lowest risk and often have the lowest yields.

Why do bond prices and yields fluctuate?

The key feature of bonds is that they are “securitized” and can therefore be traded on the market.

This means they can be bought and sold between investors, and hence their price can fluctuate based on demand and supply. The price can be affected by a range of factors such as:

• Inflation
• The prevailing interest rate
• The perceived likelihood of default of the lender

Because the coupon on the bond never changes, this creates an inverse relationship between the bond price and the yield. This is a critical property of bonds you need to understand:

• If the bond price goes up, the yield goes down.
• If the bond price goes down, the yield goes up.

We can demonstrate this by continuing with our example above.

Say CashStrapped & Co. was going through hard times and struggling with profitability. The company’s default has increased, and therefore, the market price for their bond decreases from $10,000 to $5,000. This price reduction reflects the fact that investors believe CashStrapped & Co. will be less likely to repay its loan in full.

The coupon on the bond remains unchanged. Therefore the new yield compared to the new, reduced price is:

Yield = $500 / $5,000 = 10%

The yield has risen from 5% to 10%. This reflects the increased return the investor requires to compensate them for the higher risk they are taking on.

Why is it useful to understand bond prices and yields?

There are a number of reasons why it’s useful to have a basic understanding of how bond markets work. However, two key ones are explored below.

Bonds are, conventionally, considered to play a key role as part of a diversified investment portfolio

Bonds typically tend to be less volatile and risky when compared to equities. You will often hear talk of a “60/40 portfolio”. This refers to a conventional investment portfolio that is made up of 60% equities and 40% bonds.

Bonds offer a way to reduce the volatility of your overall portfolio as:

• They are usually much less volatile than stocks in general, thus bolstering your portfolio and reducing overall volatility.
• Over the long term, bonds and equities have tended to be negatively correlated, i.e., when one does well, the other does less well and vice versa. This means they naturally act as a form of hedge within an overall portfolio.

NB: As an aside, given historically low-interest rates presently, I’m personally more drawn to precious metals to provide this diversification and hedge to my equity positions. However, many investors do very well with bonds.

The understanding of bond prices and yields can give us insight into other markets

For example, a key macro indicator many people (including myself) pay attention to is the yield on the 10-Year US Treasury Note.

If the year on 10-Year Treasuries is rising, it can be bad news for certain other asset classes. For example, precious metals like Gold and Silver tend to underperform as real interest rates go up, as they provide no yield themselves.

Rising yields also tend to be bad for growth stocks. This is because growth stocks are priced largely based on their future earnings potential. So if interest rates rise, this reduces the present value of their future earnings on a discounted cash flow basis. It also increases their cost of investment capital to fuel their growth.

A fall in yields on 10-Year US Treasures also can suggest a rise in demand for US Dollars. Perhaps driven by an investor “flock to safety” of the US Dollar or by central bank Money Printing and debt monetization.

It’s also worth paying attention to yields on corporate bonds and indeed other sovereign bonds. Rising yields could suggest the company (or country!) is in trouble or at risk of bankruptcy. Remember, higher yields typically mean higher risk.

These are just a few examples of why it’s important to understand bonds, what they are, and how they interact with other markets. Whether or not you actually utilize them as an investment vehicle, knowing how they work will deepen your overall understanding of financial markets.