Thoughts On Money
Hello TOM subscribers! This week we have a reader submitted question:
Could you provide a basic explanation of how bonds work? (Yield vs. price, yield curve, etc.)
What a great question and a timely one. The yield curve has made a lot of headlines recently, which probably leads many of us to wonder what is a yield curve and furthermore, what are bonds?
Reader submitted questions are my favorite because this commentary is intended to help you – the reader. Any and all questions are welcome: firstname.lastname@example.org
Off we go…
It Takes Money to Make Money
Ok, so let’s start off simple, what do all companies need in order to run their business? If you guessed money, you are exactly right. As the old adage goes, it takes money to make money. So how do companies go about raising money? They either sell partial ownership of their business in the form of a stock or they borrow money in the form of a bond.
So, a bond is debt. This debt is typically issued with an agreement to pay a particular interest rate over a particular time period until the initial amount borrowed is paid back. Here’s a easy to understand example – The US government might issue a 2-year bond that pays a 2.75% interest rate. If I was to purchase this bond, which means I am a lender to the US government, then I would expect to let them borrow my money for those two years and each year I would be expected to be paid 2.75% interest on the money I lent. What happens at the end of the two years? The bond matures and the borrower, in this case, the US government, pays back the initial amount borrowed.
Some Quick Vocabulary Terms
When you hear folks discussing bonds, they might use some vocabulary that you are not familiar with. Rather than the interest rate, they might say “coupon.” Coupon is the listed interest rate on the bond that is issued and can be calculated by dividing the annuals payments by the issue price. You also might hear someone refer to the “yield” (or “current yield”) of the bond. The yield is the annual payments received divided by the price you pay for the bond. Coupon and yield can be the same if the price you pay is the same as the issue price (also referred to as the “par value”) but they can differ when you pay a discount or premium when purchasing the bond – we will discuss these terms in a bit. Lastly, you might hear someone refer to the time period that the money is borrowed/lent as the “term.” Is there more bond terminology than this? Yup. Are we going to review it now? Nope.
The “Secondary” Market
This next part can be a little tricky to understand, so let’s go back to our example from earlier. I agree to let the US government borrow my money for 2 years and they agree to pay me 2.75% interest on the money I lend. The term is 2 years and the coupon is 2.75%. I am one year into this agreement and I realize I need my money back – YIKES! What do I do? I need to find a buyer to take my place as the lender. This shouldn’t be too complicated of a concept because we actually do this pretty regularly in our everyday life. We buy something that we no longer need, so we sell it. We might use eBay or Craigslist or even a garage sale to sell our unneeded items. These are all types of “secondary markets,” a place where formerly purchased things are sold a second time.
Now, obviously where I sell my old dust collected bike is going to be a different marketplace than where I go to sell my bond, but the concept is similar. Have you ever had your mortgage provider changed? Same thing, the original lender who issued your mortgage decided to sell that debt on the secondary market to a new lender. The great thing about public markets (a type of secondary market) is that you have a lot of participants. As an example, at the New York Stock Exchange stocks are bought and sold by folks from all around the globe participating in trades second by second. The bond market is the same. This makes for efficient pricing because there are many bidders. This is the same reason you might prefer to sell your things online vs. on your driveway – you get a bigger audience of potential buyers.
Discounts and Premiums
Ok, now I have a secondary market to sell my bond, but what price will I get from the buyer? Let’s say I bought a $1,000 2-year treasury note with a 2.75% coupon. I know it is easy to assume that I would be able to sell this for $1,000 at any time and the buyer would just slide in as the new lender, but it isn’t that simple. Remember, we have a lot of participants in this marketplace and the pricing for this should be very efficient. For our example, let’s assume that currently, the US government is now issuing 1-year debt with a 3% coupon. My bond has one year left, has the same lender, but the new rates that are being issued are better than the rate on my bond (2.75%). This means I will most likely need to sell my bond at a discount to the price I paid for it. This discount will compensate the new buyer for the lower coupon on my bond. What if the new issues for 1-year bonds were at 2.5% (lower than the rate on my bond)? Then I would sell my bond at a premium to the price I paid for it, the buyer would compensate me for my higher coupon bond. The math behind this is always meant to equalize the total compensation for the bondholder based on the current rate environment.
Our example here was really simple, but in the real world, there are more variables at play. All of these variables are inputs that affect the resale price of a bond. If the economic environment is better or worse than when we purchased our bond, it will affect the resale value. If the creditworthiness of the lender is better or worse than when we purchased our bond, it will affect the resale value. If the general investor sentiment in the marketplace has changed, it will affect the resale value of our bond.
What is Risk?
Here’s a question though, how are these interest rates initially determined? Just like you might expect, these interest rates are determined based on risk. The interest rates a company will pay depends on how “risky” it is to lend to that company. We define risk by how likely a company would be to default and not be able to pay you back the debt they owe you. This risk is easier to define in the short run because there are fewer variables and harder to predict over long periods. Therefore, all things being equal, longer-term bonds should pay a higher interest rate. Think about your mortgage, the rate is often dependent on your credit score (how “risky” it is to lend to you) and typically shorter-term mortgages, 10 years vs. 30 years, are lower rates.
Now think about these interest rates on a spectrum from really safe to high risk. In a former issue of TOM titled, CASH – From Zero to Hero? we talked about the “really safe” end of the spectrum. In the financial world, the 3-month government treasury is deemed the “risk-free rate.” Why does it get this title? Because it is a very short-term (3 months) and there is a low likelihood of the US government defaulting. The other end of the spectrum would be high yield bonds, also known as junk bonds. They get this ugly title because they are bonds issued by companies with a higher likelihood of default and therefore pay a higher yield.
So, remember, the interest rate is a reflection of the embedded or assumed risk. Many folks naturally associate bonds with safety and stocks with risky, but could there be a stock that is a more conservative investment than a particular bond? Yes.
Now, Let’s Zoom Out
I think we now have a good understanding of what a bond is, how the price of a bond can move, and how interest rates are determined. Let’s pivot to a conversation about the yield curve. The yield curve is a zoomed out snapshot of a collection of bonds with different maturities. The yield curve represents bonds of the same risk (credit rating) with differing maturities and most often is used to reference US Treasuries (bonds issued by the US government). The y-axis expresses the interest rate (yield) and the x-access expresses the time (term). To illustrate this, I grabbed some data from www.bloomberg.com and plugged it into excel to provide an example. This is the yield curve as of 3:07 pm on December 11th, 2018:
So, what does this tell us? Descriptively it gives us a view of how we are compensated (yield wise) along the term spectrum of 3-month to 30-years. This matters because the shape of this curve changes over time and may tell us something about the environment we are in. A steeper yield curve, meaning the spread between the long-term and short-term rates are wider, might be predictive of a stronger economy, potentially projecting rising inflation expectations and higher future interest rates. A flattening yield curve may signal the opposite and project weaker economic growth. I use these terms “might” and “may” intentionally because the yield curve is not a crystal ball for what the future has in store, but rather a reflection of the market sentiment and what the market participants think the future might look like.
Steep, Flat, What About Inverted?
This leads us to our final topic, the topic that has captured so many headlines recently – the inverted yield curve. An inverted yield curve would mean that longer-term rates were paying less than shorter-term rates. WAIT A TICK! We just spent so much time talking about risk and how logically longer-term rates should always pay more than shorter-term rates issued by the same borrower, right? Yes, this is true and logical and that’s why an inversion of the yield curve is rare. Why this makes headline news is because in the past, the rare occasions when the yield curve did invert, it was followed by a recession. IMMEDIATELY FOLLOWED BY A RECESSION!? No, some occasions it was 10 months, others it was 2 years, and I believe the average was somewhere around a year and a half. Like many tools in finance, they can’t be used to predict the exact future of when or if an event will happen.
Here’s the thing though, when the yield curve does invert it means that the market participants, you and I, believe that this recession is coming. We are the buyers and sellers of the bonds across the whole curve, so what does it mean if we are willing to accept lower rates for the longer-dated bonds? It means that we think sometime between today and these longer-dated bonds that economic growth will slow down (recession), the fed will lower interest rates to spike economic activity, and the rates we’ve locked in for longer-term today will be better than future offerings. There is a lot to swallow in those last few sentences, so let’s reiterate that point with a hypothetical inverted case – If I buy a 10-year bond today that pays 3% when the 2-year bond is paying 3.25% (that’s an inverted curve) I am ok with the 3% rate because I believe that in the near future recession will occur, the fed will lower rates, which means the 2 year rate will be lower and the 10-year will be lower as well. If I am a bond buyer and this played out as I predicted, then my 10-year bonds locked in at 3% could look a lot more attractive in the future when the effects of recession have set in.
Back to reality though, the yield curve is not inverted right now. Is it flatter than it has been in the past? Yes, but that is different than inverted. Has the 2-year and 5-year fluctuated to where the yield on the 2-year has been a bit higher? Yes, but an inverted yield curve typically refers to the relationship between the 2-year and 10-year. David Bahnsen has written some great material in the Dividend Café on this (see And That Yield Curve?) slight internal inversion between the 2-year and the 5-year. Lastly, if an inverted yield curve has led to a recession in 5 out of the last 5 cases, does it mean it will again? I suppose not, the markets have no perfect indicators and are well known for making a fool out of most of us that think we can predict what the future has in store. As David Bahnsen said in his piece, “The takeaway? It is a better media soundbite than it is an investor message.”
Ok, that was a lot to take in and kudos to you if you made it this far. These topics can be complex and although I try my best to simplify them they can also lead to more questions. Feel free to reach out with any questions that you may have and ask any new questions that you want to be addressed here in TOM.
See you next week!
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