Turns out bonds can get crazy, too

For better or worse, stocks still haven’t gotten off the roller coaster… and the drama is getting a little old, to be honest. Although stock fluctuations are important to monitor, they also tend to hog the spotlight and can easily divert attention from important goings-on elsewhere.

The bond market, for example, is a full three times bigger than the stock market, making it extremely impactful for investors and economies. You’d never guess it from their relative lack of press coverage, but bonds have also seen major developments recently, and they’re important to understand.

What’s going on with bonds lately?

Many of us rely on bonds for a certain amount of “fixed income,” thanks to their safety and consistency relative to stocks. But lately they seem to have also caught a touch of the bug that is afflicting stocks – and, in fact, they may be partially contributing to it as well.

The first and perhaps most obvious thing to note is that bond prices are also in decline. To wit:

  • Short-term bonds are down about 3% year-to-date
  • Intermediate bonds are down about 10% YTD
  • Long-term bonds are down about 20% YTD (ouch!)

There are two other facts worth noting as well:

  1. A major – but not singular – cause of these falling prices is the Fed’s recent movement to raise interest rates (more on how that works here).
  2. A major – but, again, not singular – effect of these falling prices is a widespread selloff of bonds, as indicated in the chart below:

Some might see this as non-news, as it looks pretty much the same as what’s happening in the stock market (if a bit less dramatic). Others, however, might see it as even more of a grim omen: if even stable assets are declining, then things must really be bad!

But both responses assume that bonds are just a kind of slow-cooked version of stocks: that they grow and shrink and generate profits in basically the same way, only… less. And while that assumption might work at a superficial level, it’s rather misleading in this case.  To understand why a quick(ish) refresher might help.

What even are bonds, anyway?

How exactly does the bond market generate income for investors, and how is that income different from stock earnings? There are many moving parts, but we’ll break down a few of the big ones.

1: Sometimes, giving is receiving

Although we usually treat bonds as a product, recall that they’re ultimately loans. When you “buy” a bond directly from its issuer (whether the government or a corporation), you’re actually lending money to them. In return, the corporation or government issues a promise to pay the loan back with interest.

In other words, the price you pay for the bond is effectively the loan principal, and the return you get is the interest paid on it by the issuer. Finally, the bond’s maturity (the point at which the issuer must pay back the principal to you) is really just the term of the loan. Even if the issuer goes bankrupt before then, you’ll be first on the list to get paid out.

So that, in a nutshell, is one major advantage that bonds have over stocks, and part of why they are considered relatively safe investments.

2: Slow and steady (might) win the race

Like any other type of loan, bonds are subject to a strict timeline. And this is where they get their other big advantage: consistency.

Remember the “fixed income” that so many of us get from bonds? As you may have guessed, it’s basically just interest payments. And unlike stock returns, interest payments have their quantity and frequency locked in, from the moment a bond is issued to the moment it matures.

The relative value of those payments is still affected by many factors – inflation, prevailing interest rates, the issuer’s creditworthiness, etc. More on that in a minute. Point is, much like how you can count on getting your principal back, you can also count on these consistent periodic payments.

But now for the monkey wrench. Everything we’ve discussed so far rests on the assumption that you’ve purchased the bond directly from the issuer, and that you’ll hold onto it until it matures. So, what if one or both of those things isn’t true?

3: Getting it back vs. paying it forward

Like a stock share, a bond can change hands indefinitely. If, for example, its initial holder sees a juicier opportunity elsewhere, or wants to make their money back fast, or even fears the issuer might default on them, they can always sell the bond to someone else.

Similarly, anyone can buy a bond from its holder. But if the holder isn’t actively trying to get rid of it – e.g. in a scenario where prices aren’t falling – then the hopeful buyer will have to sweeten the deal by offering more than its “face value,” or the amount the initial holder paid for it.

Initial exchanges between bond issuers and buyers make up the so-called primary market, while those subsequent third-party swaps form the secondary market. Although bonds are “designed” for the former, the latter is where most of the action happens with them.

As a bond gets swapped around on the secondary market, its market price starts to diverge from its original purchase price (also known as face value or par value). But even as its market price moves around – and prevailing market interest rates too – the interest payments on it remain fixed.

So the question of the bond’s relative value suddenly becomes much more significant – and much more hairy. And this is where the current situation gets interesting.

What does this mean for me?

You’ll hear bond investors talk a lot about yield, which we briefly mentioned earlier. In brief, yield is a way of measuring a bond’s value relative to the surrounding market, rather than its value on paper. There are many different ways to do so, and they get complicated quickly. But the basic concept has two key implications for today’s bond market in particular:

1: When prices fall, yields rise

In general, falling bond prices go hand-in-hand with rising bond yields. If a bond was initially purchased for $1,000 with 15% annual interest, that means its holder can expect a payout of $150 a year. Not much, but again – the consistency is nice.

Suppose that Joe Bondholder wants to get rid of this $1,000 bond, however. To his frustration, he can only manage to pawn it off for $990. The new buyer, however, is better off than Joe was. Measly though it may be, that $150 a year represented 15% of Joe’s original investment – and it now represents a whopping 15.15% of our lucky newcomer’s investment.

2:  When bond yields rise, stocks look less attractive

Because stocks are much riskier than bonds, they need to maintain a relatively high rate of return if investors are to consider them a worthwhile alternative to bonds. So institutional investors use something called the equity risk premium (i.e., the difference between stock and bond RoR’s) as a benchmark to evaluate possible stock investments.

If a given stock’s ERP meets an investor’s target level, then he or she will probably buy it. But if bond yields are increasing, stocks’ ERP will shrink – making them look less appealing by comparison. This, in turn, may coax investors out of the stock market and depress stock prices further.

1 https://seekingalpha.com/article/4339027-s-and-p-500-dividend-yield-vs-10-year-yield-blowout

Where is the bond landscape headed?

All other things being equal (which, of course, is never the case), this drama should theoretically even out again before long.

As we’ve established, bond prices decrease when interest rates increase and, in turn, their long-term yields go up. This eventually attracts more buyers to the bond market; then, as with any other product, increased demand leads back around to increased prices.

The only difference here is that instead of raising bond prices directly, the Fed will instead lower interest rates again. Remember, bonds represent debt rather than assets; so if the Fed has enough takers for the bonds it wants to issue, it will also try to pay as little interest on them as possible.