Bonds Are An IOU
Do you hear the word bonds on the news and have no idea what they are talking about? Let’s unwrap them and give ourselves a good basic understanding.
A bond is simply a document with an IOU written on it. It is the document that contains the details of a loan.
Can I Borrow Twenty Bucks?
In day-to-day live we use different lingo, but the concept is the same. "Can I borrow twenty bucks?"
I'm asking you for a loan, and being the kind person that you are, you agree to lend me the money. But, kind doesn’t equate to foolish, so to make things official, you ask me to put it in writing. Easy enough, I write down on a piece of paper that I owe you $20, that I will pay it within a year, and I’ll add $2 for interest. I just created a bond.
By scribbling out the details onto a document, I created a bond. As an individual, I ask if I can borrow $20, but if I were a business, I would offer to sell you the bond for $20 instead. In both cases, I am borrowing $20 and agreeing to pay back $22. The only difference is in terminology.
Bond Yield = Interest
Now let’s go a little bit further and look at bond yields. The bond yield is another term for the interest rate you pay. Remember, I wrote down that I will pay you an extra $2 in interest? That is the yield on the bond.
This next bit is where people get tripped up.
Bonds Down, Yield Up and Vice Versa
The price of the bond moves in the opposite direction to the yield of the bond.
Let’s look at how that works. Going back to the example above, we have a $20 bond that yields $2, or 10%. One year from now, I owe you $22.
You bought the bond from me for $20. You handed me a $20 bill and I handed you the bond.
Today, you bought the bond for $20, so when you receive $22 in one year you will have earned 10% on your investment.
But one year from now is a long time, and a lot could change. What if you lose your job and can’t wait a year to get your money back? What if you see a t-shirt for sale that you are just dying to buy, but you have nothing in your wallet but a bond?
You could ask me to pay you back early, but remember, according to the details of the bond (IOU) I have a year to pay you back. I'm not obligated to pay you back early.
But as the bondholder, you have another option. You could sell the bond to somebody else. It is worth something, since it is a legally binding document promising the payment of $22 in one year.
Bond Prices Fluctuate
The thing is, nobody is obligated to buy that bond from you. Nor are they obligated to give you the full face value of the bond. You might think I am trustworthy enough that you will float me a loan for a year in exchange for 10% interest, but what if nobody else feels that way?
In that case, someone may be willing to buy the bond from you, but for a lower price. For simple math purposes, let’s say the best offer you can get for that bond is $18, and in your desperation, you agree to sell it.
Now the new owner has a document offering the same $22 in one year, except he only paid $18 instead of $20. He will earn $4 profit on his $18 loan, whereas the original lender (you) paid $20 for the possibility of only $2 in profit.
$20 bond + $2 interest = 10% yield
$18 bond + $4 interest = 22% yield
The cost of the bond dropped for him, but since the amount he will receive didn’t drop, the yield went up.
See how the yield rose as the price of the bond declined? Congratulations. You just solved the mystery of the credit markets. Next time you hear CNBC talking about bonds you'll have a basic understanding of them. You can really wow your friends at the next dinner party!
Seesaw Photo by Markus Winkler on Unsplash