Three Reasons Why You Need to Understand Bonds
Keep hearing about ‘yields,’ ‘notes’, and ‘coupon rates?’ I can explain.
Before I learned about finance, a bond either signified a deep friendship or referred to the venerable British secret agent.
But in financial markets, a bond means debt held by a government or a large company that you can purchase in exchange for interest, plus the face value you paid for it.
So, why are bonds important? First, let’s define what they are.
WHAT IS A BOND?
Governments and companies issue bonds at a fixed unit price with an attached interest rate. The rate is fixed, making a bond a fixed income asset.
While the interest is fixed, the unit price is not. The price of a bond can be bought and sold on the public market. They become more or less valuable based on the interest rate attached.
But why are these bonds offered to the public? Why wouldn’t governments or large companies seek income from one place, like a large bank?
Say the U.S. government needs a trillion dollars for a new spending plan to improve defense, social security, and infrastructure. While banks might be able to offer a portion, a trillion dollars might be too much for Bank of America to take from its balance sheet.
By offering bonds to the public, it diversifies the debt. It allows a vast array of individuals to assume the role of lender. Think of it as crowdfunding on a macro scale.
Here are three reasons why understanding them better will make you more financially savvy:
#1 — BONDS ARE A KEY PART OF ANY INVESTMENT STRATEGY
If you have all your eggs in the bitcoin basket, or the Tesla basket, you’re overexposed to risk. You must diversify.
Many investors do so by holding fixed income assets, which almost always include bonds. You can either buy them directly or hold them as a part of your mutual fund portfolio.
The steady income of bonds makes them a reliable source of income for investors.
Bonds typically do well in ‘risk-off’ environments, when stocks are viewed as too ‘risk-on.’ Not only can you make a guaranteed percentage, but you also receive your loaned amount upon completion of the term, known as the ‘maturity rate.’
It’s important to note that bonds typically do well when equities suffer, as they’re a safer bet.
This is the first environment where both stocks and equities are suffering, and that’s due to high inflation cause interest rates to rise faster than usual. It won’t last.
Bottom Line: Bonds are one of the most basic instruments of any portfolio. If you’re overexposed to risk, consider bonds to diversify.
#2 — BOND PRICES SAY A LOT
Like any market product, its price will vary. So while the ‘coupon rate’ (interest paid) may be fixed for the term of the ‘note’ (bond), the price of the note will fluctuate.
But why do prices fluctuate? Because the term can vary greatly, from two to thirty years. A lot can happen in a short amount of time.
Imagine you bought a 3-year Note at the beginning of 2020: by now you’d have seen a worldwide pandemic, a new U.S. president, a new war in Europe, and inflation not seen since the 1980s.
One major factor that affects bonds are prime rates. Due to inflation, interest rates have soared across the world.
When money becomes more expensive, it becomes riskier to invest in equities. Because fixed income is more stable and less risky, bonds become more desirable.
Bottom Line: The variance in the price of bonds often indicates the outlook of an economy.
#3 — BONDS PREDICT A RECESSION
In the late 1980s, an economist named Arturo Estrella developed the inverse yield curve metric, which has indicated every major recession.
Bulls love to decry its accuracy, but it hasn’t failed in fifty years. Generally, the 2-year and 10-year notes are analyzed, and when the yields invert, a recession follows.
What does that mean? Firstly, ‘yield’ represents the interest (or coupon rate) that you are paid as a debt holder.
Say you hold a 2-year note, yielding 1.5%, and a 10-year note, yielding 4%. The economy is doing well. Your risk, as a debt holder, is less at two years than it is at ten, and your coupon rates reflect this.
But suddenly a confluence of events destabilizes the economy. Shorter bonds become more attractive as the long term forecast looks gloomy, and 2-year bond prices increase, making the coupon rate more profitable.
This leads to the 2-year paying a higher yield than the 10-year, which tells traders, investors, and analysts that the market outlook is bleak.
Due to the computerized nature of trading in the modern age, this metric can signal auto selling on a grand scale and lead markets to tumble.
The inverse yield curve has predicted the 2001 recession, the 2007 recession, and yes, very recently. It’s very reliable.
Bottom Line: If you hear ‘inverted yield curve’ and don’t know that refers to bonds and its greater implications, you may be left holding bags.
CONCLUSION
It’s easy to fall into the allure of tech stocks, crypto, and precious metals. They can all help grow your wealth, but they can also lead you to ruin without proper risk mitigation.
Bonds offer a safe, less risky source of income. They hum along nicely in bull runs, and take less of a beating in bear markets.
While it seems there’s no safe place other than holding cash, bonds and fixed income could be a haven for the potentially rocky road back to a bull market.
Disclaimer: I am an active investor in the markets. While I present what knowledge I have accrued, none of this is to be taken as financial advice.
