To many people, bonds are the ugly step-child of the financial markets, with nowhere near the interest or appeal of the equity or commodity markets. It is certainly true that equity markets have historically out-performed bonds over long time horizons, and that commodity markets express frantic volatility that generate both euphoria and despair within the hearts and minds of traders on a daily basis.
However, it is also true that bonds (i.e. debt) is the single largest financial market on the face of the earth with aggregate global obligations in the neighborhood of $100 Trillion. (Yes … Trillion)
Thus, as informed investors it makes sense for us to understand how bonds work and what they tell us.
To start, it is important to understand how bond prices are quoted, and what these numbers mean. Bonds are almost universally quoted in terms of yield, which represents the annualized rate of return you will earn if you purchase a bond and hold it until maturity. However, the individual bond your purchase may be priced at a discount, at par, or at a premium. The reason for this is because of the multiple components to bond yields.
These components are the current purchase price, the future interest payments (also known as coupon payments) and the future repayment of the bond face value upon maturity.
The purchase price of a bond can be above or below the “face” value of the bond. Typically, this variance is highly correlated with the relationship between the posted rate of interest for the bond relative to the market interest rate for new debt. When the purchase price is below the face value for a bond, it is said to be selling at a discount. When the purchase price is higher than the face value, it is said to be selling at a premium.
The interest payments from a bond are also referred to as the “Coupon” payments. These residual payments are the compensation that a lender receives as compensation for allowing somebody else to borrow their capital. When the interest payments relative to the face value exceed the “market” rate of interest, the bond typically sells at a premium. Conversely, when the interest payments are below the “market” rate, the bond typically sells at a discount.
At the maturity date for a bond, the entire face amount is due to the owner of the bond. If the bond was purchased at a discount, this amount will exceed the nominal amount paid. If the bond was purchased at a premium, this amount will be less than the amount paid.
How Does This All Come Together?
The aggregated cash flows of a bond from interest and the return of its face value at the maturity date. When a “yield” is quoted for a bond of a certain duration with a given rating, it represents the Internal Rate of Return that an investor will earn if the bond is held to maturity. As the yields of bonds increase or decrease, it tells us how the bonds of that risk and time duration profile are being viewed in the market.
What determines the Market Interest Rate?
Fundamentally, the market rate of interest is determine by three variables. The first is the relative risk of the bonds (as expressed by their “rating” from a service like Standard & Poors or Moodys), the second is its duration until maturity, and the third is the capital flows in or out of similar bonds in the marketplace.
When capital is flowing into bonds, the increased buying pressure will increase purchase prices and decrease the overall yield. Conversely, when capital is flowing out of bonds, the selling pressure will decrease the purchase price and increase the overall yield. In this way, bond prices and yields are inversely related, meaning that increases in one are accompanied by decreases in the other.
Why Is This Important?
The bond market is very large, and viewed by the financial community as being relatively low risk. This gives us a window into market sentiment. When capital is flowing into bonds, it tells us that the market wants to reduce its risk profile by moving capital out of equities and commodities. Conversely, when capital is flowing out of bonds, it tells us that the market is looking to take on more risk.
Of course, in an environment of central bank intervention, bond prices can be increasing while private capital is flowing into equity and commodity markets. This represents another dynamic of the bond market that gives us visibility into market sentiment, since central bank bond buying is typically concentrated in central government bonds. By comparing central government bonds against municipal government bonds and corporate bonds, it will provide a window into market sentiment that can help each investor make higher quality decisions.