How Do Bonds Work?

Interest rates are going to move up.  Of course I don’t know how quickly that’s going to happen but it will happen sooner or later.  If you own bonds that’s really important to understand.  Bond buyers are attracted to safety and attractive yields but sometimes that strategy can backfire.  That’s because as interest rates rise, most bond prices decline.* That might sound very confusing but don’t sweat it.  Within 3 minutes you’ll understand this fully.  Feels good already….right?  Nailed it!

How Bonds Really Work

Bonds are basically a loan. When you buy a bond, you are loaning someone money. At the end of the term, (you hope) they pay you back the money you lent out. If they don’t repay you, you have a variety of ways to try to collect but none of them are very good. The best alternative is to haul the borrower into bankruptcy court but don’t hold your breath.  It takes years, costs a fortune and bond holders usually get back far less than they invested.  But why be so dreary?  Let’s assume the company you loaned money to stays solvent.

During the term of the loan, you receive interest payments. In the case of bonds, you’ll receive those payments every six months. And those interest payments never change.  They are fixed (as long as the borrower stays afloat).

If Your Payments Are Fixed Why Does The Value Of Bonds Change?

Yes, your payments are fixed but the prevailing interest rates available in the market change all the time.  This is the key and what moves the price of your bond and the bond market.

Let’s take a look: Assume you buy a bond for $100,000 when market interest rates are 5% and the bond interest rate is also 5%. You’ll receive $5,000 each year you hold the bond – two payments of $2,500 every six months.

Prices Drop As Rates Rise

In Year 2, let’s assume interest rates go up to 10% in the market and you decide you’d like to sell your bond and get that higher interest rate. Your income on the existing bond is still 5% — the nominal rate never changes like I said and the income dollar amount doesn’t ever change.

Let’s say you come to me and offer to sell your bond for the price you paid — $100,000. Am I going to buy it? No way. Why not? Well, the income I’ll receive is $5,000 if I buy your bond – remember, that doesn’t change. But since prevailing interest rates are now up to 10%, how much would I have to invest elsewhere to get a payment of $5,000 every year? The answer is $50,000. I could invest $50,000 and, since prevailing interest rates are 10%, if I do I should be able to get a payment of $5,000.

So why would I buy your bond for $100,000 when I could invest $50,000 and duplicate the same income you are receiving? The answer is, I would have to be a complete nincompoop to do so.  Sorry Charlie.

If you want to sell your bond, the most you’ll get is $50,000 for it. Nobody cares what you paid for the bond.

Prices Rise As Rates Drop

Now, let’s assume you didn’t sell the bond in year 2 because you didn’t want to lose so much money. In Year 3, you get lucky. Interest rates drop to 2.5%. Now with those interest rates, I’d have to invest $200,000 in order to get $5,000 in interest right? ($200,000 times 2.5% yields $5000).  That means your bond is now worth $200,000 and you won’t accept a penny less if you want to sell it.  If I come back to you in year 3 and tell you I’ve reconsidered and will take that bond off your hands for $100,000.  You tell me to take a hike.

Get it?  As interest rates go up, your bond becomes worth less because I can spend less to replicate the income you receive.  As rates drop, the market drives the price of your bond up because it takes more money to replicate the income from your bond.

Other Factors That Influence Bond Prices

Now, keep in mind that there are other forces that move bond prices too. One biggie is what the market thinks about the bond issuer’s ability to make payments and repay the loan completely. If the borrow is thought to be unable to make interest and/or principal payments, nobody will want that bond. It will be a junk bond and the price will drop. Other forces are the maturity or duration of the bond but that’s a topic for another day.

People buy bonds to generate retirement income and escape the roller coaster of changing account values but as you see, they do have to contend with changing values.  Of course, if they buy an individual bond and hold on until it matures, they should get their investment back so all this rigamarole won’t really matter.  They will likely be stuck with sub par returns for decades, but at least they usually get their money back.

Now that you understand bonds, are you still interested in owning any?  Why or why not?

* You can also buy inflation adjusted bonds but that option has problems of it’s own.