Investment Workshop 15: Interest Rates and Bonds

If you’ll recall, the two major components of a portfolio are equities (or stocks), and fixed income (or bonds). And bonds are, to put it simply, kinda sorta complicated. Not that stocks are simple, but everyone generally understands that when stocks go up, that’s “Good”, and when stocks go down, that’s “Bad”.

Bonds? Not so simple. It actually took me some time to finally wrap my head around bonds, and here’s what I learned.

Central Banks Don’t Determine Interest Rates. The Bond Market Does.

Whenever central banks do something, it makes headline news. The Federal Reserve raised interest rates by a quarter point! The Bank of Canada dropped interest rates by half a point! Always in exclamation remarks, because it’s such a BIG F*CKING DEAL, but what does it actually mean?

The Central Bank (of whatever country) is responsible for issuing debt on behalf of their respective government. They issue short term debt called Treasury Bills (which mature in less than a year), medium-term debt called Treasury Notes (maturing between 1 and 10 years), and long-term debt called Treasury bonds (maturing between 10 and 30 years). Each of these takes your money, pays an interest rate that the Central Bank decides, and then give you your original money back at maturity. Simple, right?

And this is when the Bond Market, meaning the aggregate of every bond trader out there, takes one look at the interest rates that the Central Banks are offering and collectively go, “Nah, we’re going to decide what the interest rate REALLY is.” This is because bond traders can decide how much they’re willing to pay for a certain issue.

Think about it. If the US government offered you a $1M 30-year bond paying 5%, and the Greek government also offered you a $1M 30-year bond paying 5%, which would you pick? Obviously the US one. But what if you could get the Greek one for only $800k? $500k? $200k? Hmmmm, maybe you might be tempted at that price. Because if the Greeks actually pay that bond (using German Euros, probably), you would be getting an effective yield of ($1M x 5%) / $200k = 25%.

What you just did (as an imaginary bond trader) is you evaluated the quality of a certain bond (in this case, Greek debt) and assigned an effective yield on a debt instrument completely ignoring what the underlying issuer intended. This is what the Bond Market does.

This happens to all bonds. The bond issuer offers a certain interest rate, then bond traders decides what it’s REALLY worth, and that is, essentially, the Bond Market.

What you’re looking at is the US Treasury Yield Curve. It shows what each Treasury maturity is currently yielding, meaning how much each issue is selling for in the Bond Market.

I have stared at so many charts like this, you would not believe. Bond Traders f*cking LOVE charts. I wouldn’t be surprised if one of these guys show up on the news getting arrested trying to build a sex doll out of printed out Powerpoint presentations.

But because that curve reflects the opinion of every bond trader on the planet, once you learn to read those charts you can actually learn quite a bit. For example, based on the shape of that curve above, you can actually predict when a recession will occur. By taking yield curves from one asset and comparing them to other yield curves from other assets, you can predict things like inflation and the likely future direction of the stock market. And by taking yield curves of one country and comparing it to another, you can predict whether a country will likely collapse. It’s pretty cool stuff, and I may cover it in a future article if people are interested.

The yield curve above was from 2017, and its shape suggested an economic expansion was underway. By contrast, looking at the yield curve in December 2023, the shape looks completely different…

This is what’s known as an inverted yield curve, and indicates that bond traders are expecting a recession to occur.

When Interest Rates Change, Your Yield Doesn’t…

So how does this affect investors? If I own a bond, and I see a news story about interest rates falling, does that mean my interest rate drops?

Nope.

For the most part, anyway.

There are some assets like Rate-Reset Preferred Shares that DO change up or down with prevailing interest rates, but for most plain-vanilla government bonds, your yield is locked in when you buy it. You bought that Greek $1M 5% bond at $200k, so you will be receiving $50k a year or 25% annually no matter what interest rates do from here on in (unless they default, of course).

…But Bond Values Do

And here’s where things get confusing. If I own a bond (or a bond ETF, as we advocate in these here Workshops) paying 5%, and interest rates change for whatever reason so that the same maturity is now yielding 4%, then how much is my bond worth? Turns out MORE. But why? Interest rates went down!

Here’s a rule I came up with to understand the madness.

Prevailing interest rates determine the yield for NEW MONEY coming into the market.

So if you have a fistful of money and you’re thinking of buying bonds, when interest rates go down you go “Aw, shucks!” because now your dollars would yield less if you bought that bond. But if they go UP, you go “Woohoo!” because now your dollars can buy more valuable, higher-yielding bonds.

Which brings me to my second rule.

Bond prices go in opposite directions of interest rates for EXISTING bondholders.

What do I mean by that?

Pretend you’re holding a $100k 30-year bond paying 5%. Now imagine interest rates move so that 30-year bonds now only pay 4%. Would you sell your $100k bond for $100k? Of course not! People with cash can no longer get 5% anymore! They can only get 4%. So you would only sell your bond for a higher price, such that the person with cash is only getting 4% on their money.

Basically, because interest rates went DOWN, your bond went UP in value.

So basically, this is how interest rates affect bonds.

If You…Are Interest Rates…You are…
WANT BondsRISE๐Ÿ™‚
WANT BondsFALL๐Ÿ™
HAVE BondsRISE๐Ÿ™
HAVE BondsFALL๐Ÿ™‚

Interest rates tend to move slowly, but as anyone who’s been invested during the COVID pandemic now realizes, rapid moves still occasionally happen, and when it does, the impact ripples through mortgages, stocks, and bonds as well. Understanding this relationship is a really important skill to have in managing your investment portfolio.

Onto the next section!

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Disclaimer: The views expressed is provided as a general source of information only and should not be considered to be personal investment advice or solicitation to buy or sell securities. Investors considering any investment should consult with their investment advisor to ensure that it is suitable for the investorโ€™s circumstances and risk tolerance before making any investment decisions. The information contained in this blog was obtained from sources believe to be reliable, however, we cannot represent that it is accurate or complete.


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