For the past week, when major stock indices suffered the worst week since the financial crisis, bonds rallied.
The low correlation with stocks is the main reason bonds are included in portfolios – diversification.
Of course, not all bonds are equal. The high yield bonds did not perform as well and had characteristics similar to stocks.
So in this post, let us have a look closer at bonds and learn how they provide some stability in fearful times.
Simplified Definition of Bonds
Bond is essentially a loan. The bond issuer is the borrower who borrows the money from the investor who is the lender and promises to return the principal with interest after a certain time period.
Governments or corporate companies commonly issue bonds as a means to borrow money.
The bond issuers determine the terms of the loan they want to take up which includes:
- The maturity date: the date which the bond issuer will pay back the bondholder the face value of the bond (principal)
- The coupon rate: the rate of interest paid on the face value of the bond.
- The coupon dates: the dates which the bond issuer will pay the coupons
- Issue price: the initial price which the bond issuer sells the bond
Bonds can be bought and sold in the bond market among investors. So bondholders do not need to hold the bond to maturity. Bondholders do not need to buy directly from bond issuers.
Price of Bond
There are two main factors that influence the price of bonds: interest rate and demand for bonds.
Effect of Interest Rates On Bond Prices
The interest rate here usually refers to the interest rate set by the federal reserve or government central banks.
Once the interest rate changes, the coupon rate of the new bonds issued by the government will follow the new interest rate.
The price of bonds are inversely related to interest rates, meaning when interest rates falls, bond prices rises and vice versa.
When Apple releases a new model of iPhone which has better specs at the same price point as the previous iPhone model and discontinued the production of previous iPhone models, the price of the older iPhone models will drop.
Why would anyone pay the same price to get an old iPhone model with weaker specs if you could get the latest iPhone model this year for the same price?
Conversely, if Apple were to release a new model of iPhone with lower specs at the same price as last year’s iPhone model and discontinued last year’s iPhone model, the price of the older iPhone will increase in price.
The old model which has the better specs suddenly became more valuable because it is no longer available.
So bonds are like iPhones and interest rates represent the specs of the iPhone model.
Effect of Demand on Bond Prices
When the demand for bond increases, the price of bonds increases.
This usually happens when market conditions turn bad and investors move their capital from stocks to bonds, in particular, US Treasury Bonds.
This is because investors perceive bonds as low risk and stable asset. It is very unlikely for the US government to default on it’s bonds.
When Apple initially released a gold iPhone model along with black and silver, the gold iPhone fetched a higher price in the secondary market even though you can buy the gold version from the Apple store at the same price as the black and silver.
Due to higher demand for the gold models, the iPhone gold models increases in price. But the face value is the same as the black and silver iPhones.
So bond prices increases when it becomes more desirable than stocks which usually happens during market crashes.
Yield of Bond
The yield of the bond is return an investor realizes from a bond.
To make it simpler, we will only use current yield to define bond yield.
Current yield = annual coupon rate / price of the bond
For example, we will look at a bond which has a face value of $1000 and a coupon rate of 2%. It is currently trading at face value with the price of $1000
So the yield is 20/1000 = 2%
If the bond price were to increase, the yield decreases. So if it were to increase to $1100, the current yield will be: 20/1100 = 1.8%
So you may see finance news talking about the 10 year yield hitting lows. That means the price of the 10 year bonds are increasing.
Bond Yield Curve
There are two factors which mainly affect the interest rate of a bond. These are maturity period and creditworthiness of the bond issuer. I talk briefly about it in my asset classes post.
The longer the maturity, the higher the rate and the higher the yield. So usually the 2 yield treasury note will have a lower yield than a 10-year treasury bond.
If you plot it yield vs maturity, you will get a curve like this:
However, when investors flock to long term bonds inflating its prices, the yield of the 10 year bond drops. When the 10 year bond yield drops below the 2 year bond yield, it becomes inverted.
An inverted yield curve looks like this:
Why do Investors Flock to Bonds?
Government Bonds, like US Treasuries, UK Gilts, German Bunds are considered safe assets. This is because there is a very low probability that the government will default on its bonds.
So you will quite likely get back your face value with interests when you hold the bond to maturity. So there is no (or very little) downside. That is why they are considered ‘risk-free’.
So when the market drops, people flock to bonds. After all, people would rather earn 2% return in bonds than a -10% return in stocks.
However, as people buy more bonds increasing its price, the yield also drops accordingly.
So there is a limit to how much a bond price can increase until it becomes negative yielding.
Negative Yielding Bonds
What does negative yield mean? It means that the investor will get back less than what they had invested in a bond.
If you were to buy a 1 year bond at $1000 which pays a coupon (interest rate) of 2% annually, the total amount of interest you will receive while holding the bond to maturity is $1020 ($1000 face value + $20 coupon).
If the price of the same 1 year bond increases to $1030, the amount you will received while holding the bond to maturity is still $1020 so it means you lost $10.
Yield becomes = -10/1030 = -0.97%
In 2019, 20% of the global bonds trade are negative yielding.
And yet, people are still buying those negative yielding bonds.
Why would they do that?
Due to recent low interest rates and loose monetary policy, the bond prices has been rallying to new highs. Institutional investors and pension funds still need to hold bonds in their portfolios for stability. They have no other higher yield alternatives for stable assets.
Another reason is that investors are becoming so pessimistic about market conditions that they are willing to accept a little loss holding negative yielding bonds than accept a larger loss holding stocks.
Monetary Policy and Interest Rates
Generally, an interest rate cut will usually have a positive effect on the market.
Low interest rates would mean cheaper financing options which will help businesses expand or invest which in turn boosts the economy.
I had mentioned that currently, we have been experiencing very low interest rates for a prolonged period of time.
However, when interest rates are already all time low, can they go even lower?
Apparently they can.
Negative Interest Rates
Some countries such as Switzerland, Japan and a few other European countries had introduced negative interest rates in their central banks.
This means banks have to pay money to central banks to store their money with them. In turn, some banks charge consumers interest rates for keeping their deposits with them.
Why would the central bank do that?
This is done to encourage people to spend their money and invest it instead of keeping it with the banks. This also encourages the bank increase lending.
Negative interest rates might also encourage investors to invest in other countries with higher rates lowering its currency which boosts exports.
However, there are also unintended drawbacks to negative interest rates. Instead of spending the money, people might just keep the money in their pillows. The banks will also have lower interest margins to make more profit.
Bonds are an important asset and should be part of your portfolio to reduce volatility.
Bonds are not correlated to stocks and tend to increase when the market plunges because people move their money to bonds.
The yield of the bond is inversely related to its price. The higher the price the lower the yield.
However, there is a limit to how high the price of the bond can rise after which the yield will become negative.
And once it enters negative, nobody really knows what long term effects it will have on the economy.