Bonds Part One

What does a dog on a teeter totter have to do with understanding bonds? Everything.

Bonds can be a challenging concept. Interest rates go up, bond prices go down. Interest rates go down, bond prices go up. This is a concept I can assure you many financial writers do not understand.

When I read this: “Today the stock market was down along with interest rates” I cringed. The sentence implies that bond prices are down. Totally wrong.

Prices for stocks may be down, but when interest rates go down  ↓   bond prices go up.↑

Picture a teeter totter. Or a seesaw. As one side goes down the other side goes up.

Right now, this little dog is perfectly balanced on a teeter totter and is probably thinking:

“I am not moving no matter how much she wags her finger at me.”

The markets are not so perfectly balanced. The way to think about interest rates is: when the dog moves forward, interest rates are going down. At the same time, the other end of the board moves up.

If the dog suddenly decides to back up, she will slide right off the teeter totter and land on her bum. Whoops. When the dog backs up and the balance shifts, bond prices are going down and now interest rates, the other end of the board, are going up.

You can see why working in the fixed income markets – the bond markets – quickly makes you the most boring person in the room. Unless you have a dog on a teeter totter.

During my career in fixed income I attended many investment committee meetings. When you come into an investment committee meeting as the bond manager you are at an immediate disadvantage. Bonds are not “relatable” or “tangible” the way stocks are. Everyone loves to talk about stocks. No one cares about bonds yielding 3%. Bonds are boring.

For every meeting I had to bring a presentation book. The “book” consisted of page after page of data that you had to craft into a most interesting story. If you didn’t make it interesting it was not uncommon for committee members to fall asleep during your presentation. This occurred primarily in the after-lunch time spot.

I had many memorable IC meetings that I could regale you with but one in particular comes to mind. I always hoped for questions during my presentations but there were many times I slogged through the book page by page with no interruptions.

This was the case in one meeting. I thought I did a pretty good job of making the bond market, interest rates and the outlook for the economy interesting, even a little exciting?

At the end of the meeting one member immediately piped up with a question. “What is your best stock idea”?

I paused and tried to wipe the look off of my face that said “What ??”  Instead I said, “You do know we are your bond manager?”

If bonds are so complicated and boring why do you need to know about them?

Because, if you have never invested in a bond or a bond fund and you have cash sitting around, you want to consider the bond market.

We are going to discuss investing cash in my next article. I started the “Investing Cash” article then stopped. I realized that I was going into the deep end of the bond market. First things first. If you understand a little bit about bonds it will help you invest cash.

Issuing bonds was a big deal back in the 1500’s. The city of Amsterdam issued the first bonds, followed by the Bank of England in the 1600’s. When a government issues a bond, they are borrowing money. In the case of the Bank of England, they issued bonds to pay for the war against France. Throughout history, sovereign governments have issued many bonds to fund wars.

Issuing a bond to raise money is also known as DEBT. If you buy a bond from the government, the government owes you. The government has promised to pay you a specific rate of interest for a specific time period. At the end of the time period they give you back your money.

If you have ever heard the term “clipping coupons” that doesn’t happen anymore. At one time physical bond certificates were issued with coupons that you would cut off and take to the bank. If you forgot that you had a bond and forgot to clip the coupon, well, this is how technology has helped. Today if you buy a bond, the coupon payment is deposited directly into your account. In the bond market the fixed rate of interest a bond pays is still called a coupon.

Some bonds have very short “lives” while others have very long-life spans. The life span of a bond is known as maturity. Like a fixed rate of interest, maturities are also fixed.

If you buy a government bond with a very long-life span, the government typically pays you a higher interest rate than a short-term bond.

You will receive a higher interest rate over the life of the bond because you are taking the risk that somewhere along the road to maturity, the government fails, and you do not get your money back. The longer the maturity, the higher the risk. You the bondholder expect to be compensated for that risk and demand a higher rate of interest to buy the bond.

Back to our friend on the teeter totter. The little dog is perfectly balanced on her bond board. If one end of the board represents interest rates and the other end represents the price of the bond, what does a perfectly balanced board equal?

Let’s say you decide to buy 25 bonds. Bonds have what is called a par value. Typically, the par value for a bond is $1,000.00. Twenty-five bonds issued at a par value of $1,000.00 per bond equals $25,000.00.

Today I am going to buy a bond that has a 3% coupon. I am going to pay $1,000.00 per bond. The bond has a maturity of 10 years. The maturity date is September 1, 2028.

For the next ten years I am going to receive $30.00 a year for each bond. I have twenty-five bonds. I am going to receive $750.00 a year in total. At the end of ten years the bond matures, and the government returns my initial investment of $25,000.00

We can’t know for sure that the dog in the picture is actually thinking about interest rates.

What happens in the human world is that the movement in interest rates and bond prices is much subtler. Interest rates don’t change so dramatically and suddenly (unless you are in Argentina where the central bank raised rates to 60% this week!) that you are airborne before you know what happened.

Now, our little friend moves one paw slightly forward. We are going to say that her center of gravity is a fixed rate of 3%. She is thinking “If I move my paw forward 5 basis points to 3.05% nobody gets thrown off and bond prices have gone up a little bit.”

“If instead I move my back paw by 10 basis points to 3.10%, interest rates have gone up and bond prices have gone down and I am slightly more tilted, but still able to stay on the board.”

The important concept in this article on Bonds is to understand the relationship between the direction of interest rates and the resulting direction of bond prices.

Yes, we have some terminology to deal with. It is all in the glossary for reference.

In part two of “Bonds” we will discuss some of the more nuanced features of bonds:

• How to buy a bond mutual fund or exchange traded fund.
• Why and how do interest rates change?
• What are call features?
• What are the different categories of bonds?
• How do I know what a good interest rate is?

This website is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation for any security, nor does it constitute an offer to provide investment advisory or other services by The Modest Economist LLC.