Bonds 101: The Fundamentals
A short series to help you understand the recent market turbulence
The last two weeks have been turbulent for the stock market. We’ve seen a sizeable sell-off across U.S. equities, with tech stocks facing the brunt of this blow. Headlines have frequently referenced rising treasury bond yields as part of the story, but what are bond yields, why might they rise, and what does this mean for markets?
This short series will decode how bonds work — today’s post focuses on the fundamentals of the bond market, laying the foundations for next week’s analysis.
This will be a recap for some and it may be brand new to others. In an attempt to keep the material accessible I have started from the very foundations.
What is a bond?
At its core, buying a bond is lending money. They are instruments sold by an entity to raise money — this could be a government or a company. The issuer of the bond promises the purchaser that, in return for lending them money, they will pay back that initial investment, with interest, over a fixed period.
Types of bonds
In most articles, when the stock market or the economy is mentioned in tandem with the bond market, they will be referring to U.S. Treasury bonds. These are bonds issued by the U.S. government.
However, there are many types of bonds:
- Government-issued bonds: U.S. Treasuries, Gilts (UK), Bunds (Germany), OATs (France), BTPs (Italy), JGBs (Japan), etc.
- Municipal bonds: issued by local authorities, such as cities, to help finance public infrastructure projects
- Corporate bonds: issued by private companies to finance their operations
These are conveniently listed in order of increasing riskiness. The riskiness of a bond depends on the default risk of the issuer. This is a measure of how likely it is that the issuer will miss a scheduled interest payment to the bondholder.
For example, U.S. Treasuries are considered one of the safest investments around because, despite having the largest debt of any country, the U.S. has the power to tax the wealthiest nation on Earth and control the world’s reserve currency — making the risk of default extremely low.
How bonds pay interest
There are two properties of a bond that are essential to understand (for now):
- Face value — the face value of a bond is the price paid to the company or government when the bond is first issued. It is the amount of money loaned to the entity. The face value of a bond is fixed, a common amount for face value is $1,000. It is important to understand that the face value is different from the price when a bond is resold on the open market.
- Coupon — this is the fixed interest rate paid to the bondholder, it is a percentage of the face value of the bond. If the coupon is 2% and the face value is $1,000, then the annual interest payment the bondholder will receive is $20. A bond’s coupon is also fixed.
Imagine you purchase a 10 year Treasury note (another word for a bond) from the U.S. Government with a face value of $1,000 and a coupon of 2%. If you hold that bond until maturity (that is, for the entire 10 year period), you will receive a $20 payment each year, up until the final year at which you will receive the final interest payment alongside the repayment of your initial investment. These payments are illustrated below:
In reality, the interest payment from a U.S. Treasury bond is made every six months, but an annual example is used for simplicity.
Now that we understand the types of bonds available, the value of holding a bond, and how these regular payments are made, next week we can focus on bond pricing in the open market. Alongside this, we will discuss how this affects equities markets and what has been driving the volatility of recent weeks.
