Bonds 101

Hello everyone, my name is Matt Sterns, and I'm creating this video today to share some information about bonds—what they are, how they work, and why I really want to share this video right now. Bonds have come back into vogue with what has happened to interest rates over the last 24 months or so, especially with interest rates going from 0% during the pandemic up to 5%. This has created a huge move in bonds, making them look more attractive as an investing vehicle. But in a lot of ways, bonds are complicated. There’s a lot of jargon used in the bond world that many people don’t understand, so I want to cover the fundamentals today about what bonds are, how their prices move, what affects their prices, and some of the jargon we use to describe bonds.

Okay, so just simply, what is a bond? A bond is a loan that investors buy for the promise of payments and security. The easiest way I find for an individual to think about a bond is to think about being the bank. You’re taking your money and loaning it to another entity—it could be the U.S. government, it could be Apple, for example—and they agree to pay you a fixed interest rate over a fixed amount of time. That is a bond. It’s the same concept as a mortgage. A bank gives you $200,000, you agree to a 4% mortgage, and you pay them 4% interest for those 30 years, or whatever you agree to be the mortgage term. Bonds work a little differently, though.

In reality, for example, let’s say the U.S. government needs a million dollars. They issue a number of bonds, and each bond costs $1,000. You can buy 100 bonds, or you could buy one bond. But to keep the example simple today, we’re just going to pretend that we buy one bond, okay? This one bond is priced at 5% for five years. So they need the money, right? And you say, “Okay, I think you're good for it, U.S. government. I'm going to give you $1,000, and you're going to pay me 5% interest." So, 5% interest on $1,000 is $50. You’re going to pay me $50 every single year, and then after those five years are over, you’re going to give me my $1,000 back. That’s how a bond works, essentially, in the real world.

It’s a little different than that mortgage example, but you can think of the bond as an investment vehicle. It’s something you can purchase to generate wealth, albeit you have to consider factors like making sure that the person you’re lending money to is going to pay you that interest and then repay your full principal in the future. There are different issuers that issue bonds, but the most common is the U.S. government. It’s the biggest bond issuer in the world, and we call those bonds “Treasury bonds” because they’re issued by the United States Treasury. Then there are other types of bonds, like municipal bonds. Say Vernon Township, for example, wants to build a roundabout. They say, “Alright, we need to raise $10 million for this project,” and they sell bonds to the public through different means. There are also corporate bonds, which are another common type of bond investment vehicle when companies need to raise money.

Sometimes companies will issue stock. They’ll say, “We’ll sell 10% of our company and give you stock,” which is ownership in the company. You buy that stock, but there’s no guarantee attached to it. You’re buying stock with the hope that the company becomes more valuable and you can sell the stock to someone else later at a higher price because the business has generated increasing profits over the years. But with a bond, they’re saying, “Hey, we need to raise money, we’re going to pay you a fixed amount of money, and then whatever you pay us upfront, we’ll give it back to you at the end.” Those are the common types of bonds you see in the investment world.

There are a couple of important factors to consider when buying a bond. They’re really common sense, but these factors determine how bonds are issued, how much interest they pay, and how they fluctuate after they’re issued. The most important thing is credit quality. Are you dealing with someone who is very reliable and certain to give you your money back in the future? For example, the United States government has the ability to print its own currency if it needs to make interest payments, so we would say their credit quality is AAA. Anything higher than Triple B goes AA, A, BBB, and so on, with plus and minus signs indicating finer grades. You could be A+, A, or A-, and so on. Anything rated above Triple B is called "investment grade." Anything below that is called "high yield." This is a term many investors have heard before—"I want to purchase high-yield bonds." High yield doesn’t mean anything other than that you’re purchasing a bond from an issuer with lower credit quality. They call it high yield because, due to that risk, they should pay you higher interest payments. We’ll talk more about the word “yield” in the future, but that’s all high yield means—it’s an issuer with lower credit quality. So, inherently, there’s more risk in purchasing high-yield debt or bonds.

Another key factor in understanding bonds is how long the bond agreement lasts. We call this duration—a very important word in the bond world. Every bond has a fixed interest rate and a fixed duration or term. This could be as short as 30 days, or as long as 30 years. There have even been bonds issued for 100 years. But the key point is that the longer the duration of the bond, the longer they’ll be forced to pay you this fixed interest rate, and the more risk there is. This is because more time means more opportunities for things to go wrong, which increases the risk that the issuer won’t be able to pay you the interest payments or return your principal at the end.

Investors can purchase a bond and receive interest payments, but at any time, they can sell their bond on the open market. So we have to separate in our minds the initial bond purchase and holding it to maturity versus the open market, where people buy and sell bonds after they’re issued or held for a while. People buy and sell bonds because they think newer bonds will have different interest rates. We’ll talk more about this in the future, but if you think your bond will become more valuable in the future, you’d hold off selling it. But the main thing to remember is that bonds will always pay 100% of the original agreed-upon face value.

So, in our previous example, we bought a bond for $1,000. It’s going to pay us $50 in interest each year (a 5% interest rate), and at the end, it will pay back the $1,000. Those two things never change. If you purchase a bond from someone in the open market after it’s existed for a few years, they’ll still pay you whatever the bond contract specifies—the same interest rate and principal repayment. This is crucial for bond investors to understand.

Let’s look at an example: You purchase a $1,000 U.S. Treasury bond at 5% interest for five years. The bond will pay you $50 every year (that’s where the 5% comes from). After five years, they’ll pay you $1,000 back. But say you hold it for three years and decide you need to sell it. Now, the government is issuing five-year bonds at 3% for $1,000, because that’s the prevailing interest rate three years later. Those new bonds are paying investors $30 annually. Because your bond is paying $50 a year, it’s more valuable than the new bonds, which are also priced at $1,000. So, if you want to sell your bond, people will have to pay extra to acquire it, because yours is paying more interest. Both bonds will pay $1,000 at the end, but yours will pay higher interest in the meantime. Your bond is now worth $1,040 because it will pay $20 extra in year four and year five.

That’s how bond pricing mechanics work and why bond prices fluctuate after they’re issued.

So, assuming that obviously our bond issuer, the company that we agreed with, is not going to default, okay, if you buy a bond and you never sell it in the open market, there is really no risk if you knew for a fact that it was going to be around. That's why sometimes you'll hear people say that short-term U.S. Treasury bills are risk-free, because unless the government ceases to exist in the next 30 to 90 days, for example, you will get the principal that you put up, your interest payment, and then your principal back at the end.

Okay, if you buy a bond at a certain rate and the prevailing rates go lower, like the example I just told you, the bond that you have is more valuable, okay? And vice versa, if you buy a bond and it's paying 5% interest but new interest rates go up to 7%, your bond is less valuable. So, as an investor, when we invest in bond funds, for example, these funds own thousands and thousands of bonds inside of them. What makes the value of that fund go up and down is what's happening with interest rates outside of that bond fund, relative, okay? So, are interest rates going up compared to all those bonds that are owned inside that bond fund? Are interest rates going lower? And so, that's what drives bond prices or bond fund prices, okay?

So, you must understand the relationship that as interest rates go up relative to what you own, okay, so assume you own something—if interest rates go up, your bonds become less valuable, all right? And this is exactly what happened in 2022. Really, the beginning of 2022 until now, interest rates that are really set by the Federal Reserve went from 0% to 5%, 5 and a quarter. Now, that rise in interest rates has caused everybody's bonds that they own to go down because every day new bonds are being issued at higher and higher interest rates, okay? But now where we're at is bonds are offering an attractive interest rate. So, now you can buy a 10-year Treasury bond at 5%, and if you hold it for 10 years and you don't go to sell it, it doesn't matter what happens in the marketplace—you'll get $50 interest payments every year, and then in year 10, you'll get your $1,000 back, okay?

But for investors that own bond funds, where there are many bonds inside of it, or if you're someone that is expecting to trade your bond at a given time, what happens relative to interest rates, interest rates relative to what you had purchased your bond at, is extremely important. And so, that's the understanding that I really want you to take away today: that interest rates and how they move affect the price of your bonds, and they're inversely related, okay? As one goes up, the other—prices—go down. As rates go up, prices go down; as rates go down, prices go up.

Okay, so a couple of other things that affect prices are, um, a few things. Credit is one thing. So, bonds can fluctuate in price if, let's say, you bought a bond from Tesla, okay? A 5-year bond paying 5% from Tesla, but they're not selling any cars. All of a sudden, they're adding—they have to issue more and more bonds, they're increasing their debt, their balance sheet's getting worse, they're losing money. All of a sudden, as an investor, as a bondholder, you say, "Oh no, they might not be able to pay me my interest and my $1,000 five years from now." So, even though nothing really happened with interest rates per se, their credit is becoming more risky, okay? And so, this can affect bond prices.

The other big thing that affects how prices move is duration, all right? Duration is the word that we use for how long—and I covered this earlier—how long that bond is going to be issued for, all right? In general, as bond prices—as duration increases, bond prices fluctuate more, okay? So, let's say, for example, you have a 10-year Treasury at 5% and new bonds are offered at 4%. Okay, your bond will increase in price roughly 10%, so it typically matches the amount of duration. One—a 1% interest rate move, okay? So, you know, in this case, it went from 5%—new bonds at 4%. Rates—interest rates—went down 1%, the value of your bond went up 10%, okay?

If you had a 30-year bond, for example, and rates go down 1%, your bond would go up 30% in value, okay? So, in example two, let's say you buy a 2-year corporate bond at 2%, new bonds are offered at 6%. That's bad news for you because everybody's going to want the 6% bonds, not the 2% bonds. So, your bonds will decrease in value roughly 8%. So, that's a 4% interest rate difference multiplied by the two years, so that's kind of a rule of thumb. And this is really where bond investing, um, really, uh, pays to know these rules, and this is, you know, why professionals position bonds and bond funds and things in your portfolio. You can really dramatically impact a portfolio depending on the duration of bonds. You can have really secure bonds with really great credit from the U.S. Treasury, but they can fluctuate tremendously based on the duration of the bond.

So, for example, in today's environment, there are a lot of risks. It looks like recession might be coming on, so you might say, "Okay, I don't want to own a bond from a risky company. I want to own U.S. Treasury bonds because I'm pretty sure no matter what happens, they're going to pay me." Well, that's fine, that's good—you don't have to worry about the credit side of the picture. But the duration is going to also affect how much that price moves. So, if you buy a 30-year bond at 5% and interest rates go up to 6%, you'll lose 30% of your value if you wanted to sell it. If you wanted to sell it, okay? And vice versa, if bonds go from 5% down to 2%, you would see a 90% increase in the value of those bonds.

So, duration is a huge factor, and it's really, um, a way to affect how much money you're going to make in the bond market. And another thing I want to say about that is all the time people refer to bonds as being less risky, and in the bond world, there are major factors that contribute to how much bond prices fluctuate. So, it's really not accurate to say that bonds are less risky than stocks. Just like stocks, it depends on what type of bonds you're buying, okay? So, I can't stress that enough.

"All right, so I want to cover what yields mean. Um, this is a technical term; it's a little bit hard to wrap your head around, but I want to introduce the idea to you. You'll hear people on television talking about yields. They'll say, 'All right, the 10-year is yielding 4.75%' or 'The yield went up 1% today.'

So imagine that over the course of one year, the U.S. government issues 10-year treasury bonds: 3% in January, 3.5% in June, and 3.25% in September. Okay, and now it's December, for example. All of those bonds are going to have their own individual market price because each of them is going to be worth a little bit different amount, as they all have different interest payments attached to them. Um, and the interest rates have gone up to 4%.

Okay, so if you purchase a bond in December, that bond is still going to pay you—let's say you purchase in December, and you go back and purchase the 3.5% bond from June—that bond is still going to pay you $35 a year. Okay, it's still going to pay you $11,000 at the end, but you're going to have to pay a different price for it. All right? The same thing applies to the 3.25% issuance in September.

What yields do is they tell us what the prevailing market-agreed-upon interest rate is at any given moment in time for a particular issuance. So let's say, in this case, it's 10-year treasury bonds. The yield is changing constantly based on what the market is predicting for future interest rates. Okay, so the yield when you want to purchase might be 4.15% in December. Your bond that you own—or that you want to buy—the 3.5% bond from June, is going to have its price based on the current yield. That current yield is based on where all the different types of bonds are trading at, because we can't look at every single issuance of bonds and get the price like you can for a stock price. That's not how it works. They aggregate everything that's being traded based on the price and get the effective market-based interest rate.

So that's what yields are: they are the current interest rate that the market is prescribing at that particular time, regardless of what anybody paid for it in the past. But that's what affects the price that you would have to sell at or pay if you wanted to get rid of your bond or purchase a new one. Okay, so yields are the market-adjusted interest rate.

Here's an example of Treasury yields, for example, over the last week. You can see the rates for all the different durations of bonds that the U.S. Treasury government has issued. All right, and you can see that they fluctuate a fair amount, just day to day. A one-month treasury is paying 5.58%, and a 10-year treasury is paying 4.6%, for example.

So you have a bond, and you're sitting at home thinking, 'Man, I bought this 10-year treasury bond at 3.5%, and it's paying me. I'm happy with it.' But what you would do is look at the 10-year yield, and you'd say, 'All right, right now it's yielding 4.58%,' and that percentage will tell you what price you would have to sell that bond at in the open market. So it's basically saying, 'Yeah, interest rates went up. Right now, we're basing the 10-year interest rate at 4.58%. Your bond is at 3%, so you're going to have to sell it at a little bit of a loss.'

Hopefully, when you see those things on TV, you can start to think, 'Okay, that's what yields mean. Yields are the market rate for each individual issuance.'

So, um, this went a little bit longer than I wanted, but wrapping your head around bonds is something that will take months and months of practice, understanding, and research. Hopefully, you take some things away from this presentation about what bonds are, what affects the movement of them, and how you can think about them as an investor.

When people say, 'Oh, future interest rates—the Federal Reserve says, you know what, we've got a big bad recession, war, whatever—we're going to have to cut interest rates,' you're thinking, 'Oh, okay, what does that mean?' If we're going to cut interest rates, that means the bond market is going to go up in value, right?

So if you can understand those fundamental things, you will be better prepared to be a bond investor and more knowledgeable about what it means and how it can affect your portfolio.

So, that's what I have for you today. Thank you for tuning in, and I can't wait to share more with you next time. Bye-bye!"

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