How The Bond Market Works

Bonds can be tricky. If bonds confuse you, I can understand why. But at their very basic level, bonds are super simple; you loan money to someone and they pay you back with interest. What could be simpler than that? Nothing.

The tricky part starts when we discuss the price of bonds and how they change over time and as interest rates fluctuate. This is especially important right now. That’s because interest rates are low. When they rise, bond prices could drop significantly. I need to make sure you understand how that works so you aren’t caught unawares.

Why Bond Prices Drop As Interest Rates Rise

The best way to explain this is by way of example. Let’s say you buy a bond for $1000 and it pays 5% interest – or $50 a year. That $50 payment will not change even if interest rates go up. That’s the key. So, for our example, let’s say rates go up to 10%. If that happens, I would only have to invest $500 (at 10%) to receive a payment of $50 a year.

If you come along and try to sell me your bond the most I’ll pay for it is $500 because that’s all I would have to invest in order to receive $50 interest. Nobody cares what you paid for your bond. They only care about how much they have to invest to get the interest payment of $50. This is why bond prices go down when rates go up. Not so bad…right?

This explains why market commentators say the market had a bad day when yields climbed. If yields (interest rates) go up it means the prices for existing bonds dropped.

When Are Bonds Expensive?

When interest rates are low, bonds are expensive. That’s because you have to fork over a lot more capital in order to get the same interest payment. Look at the example above. When rates are 5%, you have to invest $1,000 in order to generate $50 interest. But when rates climb to 10%, you only have to pay $500 to get that $50 check.

Right now, rates are extremely low. If you invest $1000 in a 30 year government bond you’ll only receive $26.70 a year interest. That means bonds are very expensive right now (but they might remain expensive or get even more expensive for a while). It all depends on what happens to rates.

Just because rates are low and bond prices are high, it doesn’t mean you should dump all your bonds. Remember, if you hold on to your bonds until they mature, you’ll receive the face value of the bond. If you need income, bonds may still be a good fit for you – although they are not the only option for income investors.

But because rates are low it is important to understand the dynamics of the bond market and what you could be faced with in the future. Are you a bond holder?  if so, are you making any changes to your portfolio?  Why or why not?