What are Bonds?
Bonds are financial instruments, that represent a loan made by the investor in the bond(bond holder), to the borrower(bond issuer). It is a means of raising money. Instead of going to a bank for a loan, bond issuers can raise money from investors – who may be individuals or institutions. These provide a fixed income to the holder of the instrument for the holding period and the principle back thereafter.
Bond yields show the effective return you get on a bond. In simplest terms, it could be arrived at using the following formula: –
Yield = Coupon amount/ Price of the bond
where, coupon amount refers to the fixed-periodical return you get on the bond.
So, when the price of a bond goes up, the yield goes down and vice-versa.
Bonds at a Discount
When a particular bond is trading at a price lower than its face value, it is said to be sold at a discount. For example, when a bond of $1000 is sold for $900, it is said to be sold at a discount. Selling bonds at a discount has mainly 2 implications: –
- It shows lower demand for such bonds.
- Lower price actually increases the effective yield. It is because, as compared to earlier, the ratio of coupon rate to price of the bond is now actually higher.
Bonds at a Premium
When a particular bond is trading at a price above its face value, it is said to be sold at a premium. For example, when a bond of $1000 is sold for $1100, it is said to be sold at a premium. Selling bonds at a premium has the following implications: –
- Shows higher demand for bonds.
- Decreases the effective yield as the ratio of price yield to price decreases due to increase in the price of the bond.
Interest Rate vs Bond Price
Interest rate, here, refers to the rate at which the central bank lends money to the commercial banks. This, in turn, forms the basis for the rate at which banks lend money to the public. As such, it is a tool for the central banks to control money supply.
Increase in money supply without any increase in production refers to a situation called inflation, which also leads to a rise in general price level. Inflation can be harmful to an economy in that it reduces the value of per unit of money.
When there is an increase in the money supply in the economy, the central bank increases the interest rates. This forces commercial banks to pass on this increased rate to the final consumers which results in loans from banks being more expensive, eventually, controlling the money supply.
As mentioned in this snip, bonds are fixed income instruments. So, the investors are assured of getting their return irrespective of the economic situation. As such, bonds become a good avenue for investment when the economy is in a downfall or a recession. This results in people flocking to bonds, which raises its price(ends up being sold at a premium) and reduces it’s effective yield.
But, when the economy is in a boom, bonds become less attractive with their fixed returns and people tend to look at alternative investments like stocks. This reduces its price and increases it’s yield. It is to be noted that, once the yield rises significantly, it becomes more attractive as an investment avenue.
The US 10 year bond and the stock market
When the WHO declared Covid-19 as a pandemic, stock markets across the world plummeted. The future ahead was unclear and possible recession was expected. This led to fixed return instruments, like bonds, becoming more attractive. It resulted in higher prices for the 10-year bonds, in effect, bringing its yields to the ground.
Over a period of 3 weeks, the yield of the 10 year Treasury Bond fell around 70%. This is because, as its demand rose, it pushed the prices up which resulted in a lower yield.
But over the last year, the Federal Reserve kept interest rates low but at the same time, kept on injecting the economy with money. It added about $3 trillion just in 2020 alone! But since the interest rates were low and the general demand was low, it did not lead to inflation. Most of the stimulus was invested in the stock market by retail investors, pushing the values of stocks, in general, higher and higher.
Most of their operations being conducted online, tech stocks saw the most growth. The tech heavy stock index NASDAQ was the highest gainer since the lows in March 2020. It gained around 90% by the end of December 2020.
However, towards the end of 2020, after the Biden administration announced its $1.9 trillion, among other reasons like the already injected $3 trillion of helicopter money, the expectations of a possible inflation arose among the investor class with economists corroborating the same. This was evident with the rising bond yields which showed that more and more investors are investing in safe haven assets like bonds, monies, which could have been invested in tech stocks, which are prone to fluctuate, indicating a potential bubble.
Bond yields increased up to around 1.6% which was where it was a year ago. This sudden uptick over a few weeks had some devastating effects on tech stocks with some shedding more than 3% in a single day with some even plummeting in double digits.
From this, it is clear that, bonds and bond yield is indeed very important to make investment decisions. They prove to be an indicator of the general health of the economy which makes them indispensable before making investing decisions.