As markets turn stormy, investors retreat to fixed income investments, typically bonds. But what are the basics of the bond market? Equities or stocks have been in the limelight for so long and with good reason. We are coming to the end of a decade long bull run where returns on equity have dwarfed those from fixed income counterparts. Most folks own bonds in their portfolio to mitigate the downside of downturns, but the particulars might be nebulous for some. If you’re thinking about acquiring more bonds, then a better understanding of bond basics may come in handy. With a little memory work and some high school math, most should be able to understand the basics of the bond market.
Basic Bond Terminology
Bonds are frequently referred to as fixed income because they are fixed contractual obligations. A stock may gain or lose value on the markets; a stock may lose its value entirely. The value of the bond contract is fixed and defaults aside a bond will generate guaranteed income for its owner. The price paid for a bond can fluctuate much like stocks on the secondary market, but the payment contract remains the same. We’ll talk more about that later, but for now let’s get a grasp of the basics.
Unfortunately, this will involve some memory work. There are some definitions we need to understand before we can proceed. Note that there are many terms in play that all mean the same thing to make things a little confusing.
Definitions of Significance
Par value: The amount of money paid at maturity (same as face value or maturity value).
Price: Amount paid for a bond on the markets.
Term to maturity: The time remaining until the maturity date.
Interest payments: Regular payments (also known as the coupon rate).
Be aware that the par value of most bonds is a USD$1000 but it is usually quoted on a base of 100. Coupon rates describe interest paid per year but interest may be paid more frequently and should be adjusted appropriately. Don’t forget that face value is the amount paid at maturity; the amount paid for the bond on the markets is the price.
Time Value of Money, Opportunity Cost, and the Discount Rate
We’ve touched on the time value of money before but it’s important here. It’s the premise that a dollar today is worth less tomorrow alternatively referred to as inflation. The coupon rate in real dollars loses value over time and the true value of a bond can’t be determined if we don’t grasp this concept. The opportunity cost of owning a bond is the interest you would have earned from the bank if your money was in an account. The opportunity cost of the bond changes when interest rates change and this in turn changes the value of the bond. The valuation of the bond determines the current market price. Unlike stocks where multiple approaches can be used to determine value, the price of a bond is formulaic and easy to calculate.
Easy being relative with a bit of math that is. The formula which need not be memorized follows; its preprogrammed into spreadsheets and computers and available on the Internet. The variables should be understood to appreciate changes in price.
B = bond price
I = interest (or coupon) payments expressed per year
k = the discount rate or the current market interest rate (prime)
n = term to maturity in years
F = par value or face value of a bond
This formula determines and states the price of a bond. There should be no mystery as to how the price is calculated.
The Yield Curve and the Relationship Between Bond Prices and Interest Rates
The graphic representation of this relationship is known as the yield curve and it is represented above (Figure 1).
Figure 1.
The bond yield price curve.
Without getting too much into the details of the formula, its graphic representation spells out some truths of the bond price-market interest rate relationship that can be thought of as rules.
Bond Rules
Rule 1: When interest rates rise, bond prices fall.
Rule 2: When interest rates fall, bond prices rise.
Depending on how savvy your math skills are, you may have recognized that the relationship between the price of a bond and the market interest rate is not linear. The curve also reveals the following to be true:
Rule 3: Bond prices increase more when interest rates decrease than bond prices decrease when interest rates increase.
The curve is always steeper to the left than it is to the right reflecting this rule. The curve is steeper for lower interest rates than for higher ones allowing us to draw our next conclusion:
Rule 4: Changes in interest rates when they are low will have a more significant impact on the price of the bond than changes when rates are high.
And when we look a bit closer at the formula, we can see that the duration of the contract has an exponential effect on the price of the bond leading us to our final conclusion:
Rule 5: The longer the investor is locked into a contract, the more dramatic a change in interest rates will be on the price.
This should make some intuitive sense without the math based on our understanding of the notion of opportunity costs. Throughout a 20-year term, an investor sacrifices potential gains made through other investments but is more likely to encounter interest rate swings. The result will depend on where the rates stood when the contract was purchased.
Different Types of Bonds and Hybrids
For simplicity’s sake in an attempt to develop a foundation, we have described a garden variety bond and have been liberal in our use of the term bond. There are other instruments which fall under the bond umbrella, all of which are bonds by a different name: bills (i.e. T-bills or treasury bills), paper, and notes.
A bond in its purest definition refers to long-term debt in excess of 7 years. Notes carry terms from 1 to 7 years and T-bills or paper are short-term issues that mature within 1 year and do not carry a coupon rate for this reason. The par value is paid when the term comes due and the bond is purchased at a discounted price. T-bills are debt issued by governments, provinces, states, and municipalities.
There are a number of variations in the standard bond contract that a purchaser can encounter and it is important to understand the terminology and deviations from the standard bond contract. Callable bonds allow the issuer to repurchase bonds at a price laid out in the original contract. Retractable bonds are essentially the opposite and allow an investor to sell the bond back to its issuer. Each of the above features factor into the price. Callable bonds are less appealing to investors and trade at discounts where retractable bonds are less appealing to issuers and carry a premium. Extendible bonds allow the purchaser to extend the term and convertible bonds are a corporate bond hybrid that allow the owner to convert the bonds into common stock.
Quality
For simplicity’s sake, we have also thought of bonds as guaranteed income. This is not entirely true. While some bonds carry an almost zero rate of default (ie, first world government issues), others are less secure. The bond purchaser must understand that the underlying quality of the bond must be taken into consideration when entering into a contract. High-risk bonds pay higher coupons to compensate the buyer for the increased risk.
There are 2 agencies that rate bonds: Standard and Poor’s and Moody’s. Both assign letter grades with some variations in nomenclature. Just like high school the closer the bond’s grade to the beginning of the alphabet the better. Both grading systems peak out with 3 A’s: Aaa for Moody’s and AAA for S&P.
An important line is the sand is drawn above BBB for S&P and Baa3 for Moody’s. Everything above this line is considered Investment Grade where Investment grade bonds are of adequate quality that they can be purchased by a bank.
The Yield Curve as Prognosticator
If you’ve been following the economy, you may have stumbled across the concept that the treasury bill yield curve can predict a downturn in the economy. Let’s break this idea down to its basics to understand the underlying concept.
The yield curve is simply a graphical representation of the relative returns on treasury bills of different terms. As we’ve already discussed, fixed instruments can be either short or long term. Short-term bonds traditionally have lower yields and long-term bonds carry higher returns to compensate the investor for opportunities lost when their money is tied up in a 20-year bond. This makes intuitive sense. But is this always the case? Well this describes the positive yield curve or the phenomenon we witness when the economy is doing well. Figure 2 depicts this “normal” relationship graphically.
Figure 2.
A positive yield curve. The curve when times are good and the economy is expanding.
The Flattening Yield Curve
Remember that we’ve shown that bond prices are inversely proportional to the returns that they yield. We’ve also shown that when interest rates rise bond prices fall. While we can think of the yield curve as a mathematical product of the bond equation, it is as much a reflection of sentiment as it is one of mathematics.
The federal reserves and central banks manipulate the returns on short-term bonds by manipulating interest rates. This is to say that interest rates have the greatest influence on short-term bond returns. Long-term bonds on the other hand are more influenced by investor sentiment. When investors are bullish on the economy, they avoid long-term fixed assets favoring the higher expected returns on equity. When they sour on the economy, they move to fixed assets to mitigate risk.
If we look back at Figure 3, the curve can flatten one of 2 ways: Short-term returns rise or long-term returns fall along with some permutation of both. A flat curve means that investors are getting the same return in yield regardless of the duration of the term. We said that the central banks have the most influence on short-term rates. When they increase interest rates, there is a corresponding increase in short-term yield. The federal reserve generally does this to cool a hot economy. They use targeted inflation to guide their decisions. When their goal is inflation rates of 2% to 3% and their indicators suggest these targets will be exceeded, they raise rates and slow the rate of inflation. This in turn flattens the yield curve. A flat yield curve is generally what we see just prior to a curve inversion.
Figure 3.
Yield curve inversion.
The Inverted Yield Curve
As the yield curve flattens and investors become aware of rising rates, fear of a slowing economy takes hold. When investors are scared, they retreat from the markets and move toward fixed investments. This in turn drives prices up. Remember there is an inverse relationship between yield and price. The influx of capital into the long-term bond market drives prices up and there must be a corresponding fall in rates of return. In this scenario, short-term debt returns higher rates as depicted below and turns logic on its head. Instead of being rewarded for long-term risk, investors are punished.
So What?
The reason that this has been thrown around so much of late is that the yield curve inversion has preceded every recession in the United States for the past 50 years. As a prognosticator, it harkens to difficult times. Having said that there is a catch. In the past, the yield curve was not followed as closely as it today and there is something to be said for that. Much of the predication was studied in hindsight and the flattening of the curve may be watched more closely by both institutional investors and the Fed. In doing so there is a potential that the Fed backs down on interest rate increases and the flattening of the curve drives policy and mitigates its impact. Only time will tell.
Footnotes
Declaration of Conflicting Interests: The author(s) declared no potential conflicts of interest with respect to the research, authorship, and/or publication of this article.
Funding: The author(s) received no financial support for the research, authorship, and/or publication of this article.