The bond market is the stock market’s less popular friend. It’s not talked about as much, perhaps because bonds don’t hold the same excitement as the stock market, and it’s a little more complex. But bonds are an important addition to any investment portfolio.

What is a bond?

A bond is what big corporations or governments get instead of loans. Instead of “taking out a loan,” it’s called issuing a bond.

Let’s say Hippo Company issues a $100 million bond. Different investors buy pieces of the bond and wire money to Hippo Company. In return, Hippo Company promises to pay back the investors, plus interest, over the duration of the bond’s life.

The interest percentage paid is called the coupon. Think of this like a rent payment – it happens on a regular basis and it’s the same amount each time.

Once the bond matures, the issuer will give the investor its last coupon payment, plus the initial money loaned out. Hippo Company pays back a total of $100 million plus interest to its investors. 

Some investors hold onto their piece of the bond for the bond’s entire life. But sometimes they get antsy and want to sell a bond before it matures. Enter: the bond market.

The Bond Market

The bond market is where investors virtually meet to buy and sell bonds to each other.

There are some weird relationships that impact the bond market. In bond world, there’s Yield, Price, and Interest Rate.

Let’s start with Price and Yield. Whenever Price is in a really good mood, Yield hates life. And whenever Price gets sad, Yield suddenly becomes super happy.

Aka: Price and Yield move opposite (inverse) of each other. When P↑ = Y↓

In bond world, a yield is the annual amount of value a bond gives an investor. This is different than the coupon rate. A bond pays the same coupon rate no matter what. Yield is determined by the value of bond’s return (the coupon) compared to how much you actually pay for it.

Think about it like buying a car. No matter how much it costs, you’ll get the same number of years out of it. But if you pay less, your overall value per year – the “yield” – is better than if you bought it for a higher price. So when a bond’s price increase, the yield decreases.

At face value, yield and coupon equal each other.

Alright, time for our third friend, Interest Rate. Interest Rate and Price kinda dislike each other. When Interest Rate goes down, Price goes up. And we already know that when Price is happy, Yield is sad.

IR ↓ =  P↑ = Y↓

When Interest Rate gets elated, Price gets mopey and Yield goes woo-hoo!

IR ↑ = P↓ = Y↑

Let’s dive in further to understand what’s going on under the hood.

How Interest Rates Move the Bond Market

Interest rates determine the cost of money. In other words, how much you have to pay to borrow money from the bank. The Federal Reserve is one of the key manipulators of U.S. interest rates.

Whenever the news media mentions the Fed is raising or lowering rates, this gets the bond market in a flurry because it affects bond prices, and consequently, yields. In a “rising rates” environment, this means Interest Rate is on the up, and Price is dropping. Aka bond prices are cheaper and yields are higher.

Why is this?

Government bonds are considered the risk-free rate. Basically, we have faith the U.S. government won’t fail on paying us back. This is an assumption, not an absolute, but to explain bond price movement, we’ll take it as fact.

If interest rates go up, the risk-free rate you can earn on your money goes up. A bond issued a year ago with a coupon based on lower interest rates now looks less attractive. Like why buy that bond when you could buy a bond issued today based off higher interest rates?

In response, bond prices will drop and yields will rise to match new bond issues.

What Higher Interest Rates Mean to Investors

When interest rates are increasing, it means money is more expensive. When money is more expensive, you can’t borrow as much money to build new office buildings or invest in things like stocks or start-ups. It’s more expensive for companies to borrow money to expand, buy inventory, and other growth activities.

Now, investors like you and me and the big dogs on Wall Street are always asking ourselves, “How can I grow my money into more money?” That’s like the whole point of investing. With higher interest rates, growing our money can be as easy as keeping it in the bank and earning interest. Putting our money into stocks that could fail is riskier than keeping it in a cozy risk-free savings account.

Same with bonds. Now bonds aren’t risk-free like interest in a saving accounts, but they are less risky than stocks. The only way you’re going to lose money on a bond is if a company defaults on payments. Which basically happens only if a company declares bankrupty.

So, when interest rates rise, we might take our money from stocks and put it into bonds because we can make more bang for our buck and feel like our money is safer.

In the short: higher interest rates makes bonds more attractive investments.

What Else Affects Bond Price

Now we’ve covered how interest rates affects bond prices and yields. But there’s also another component to bond prices: credit rating.

Credit ratings are like companies’ versions of credit scores.

A credit rating is a grade given to companies or government entities that issue debt. Credit rating agencies look at a company’s profitability, how well it uses its money, and how well it pays off its debt. Then the agency assigns the company a grade. Companies with low grades are seen as riskier – aka struggling to pay their debt. The lower the grade, the lower the price (and higher the yield). Some of the popular credit rating agencies are Moody’s, S&P, Fitch, and Morningstar.

Why any of this matters

Why should you know this? Well, if you own any bonds (like in your retirement account), rising or lowering rate talk could affect your holdings. And if you only own stocks or ETFs, rate movement can also affect the stock market.

When interest rates are rising – or speculated to rise – prices fall. Stock prices will also sometimes fall when this happens. Remember: higher interest makes borrowing money more expensive. Meaning less cash for companies to do things like grow and make more money.

Sometimes investors remove money from the stock market when it’s doing badly. But instead of just letting their money hang out in the bank, they will reinvest it in the bond market. When this happens, bond prices increase thanks to #supply&demand. More investors wanting bonds equals higher demand, but supply stays the same, so bond prices go up.

How You Can Buy Bonds

Unlike stocks, which are sold on exchanges, most bonds trade over the counter (OTC). This means investors call up a person on the phone or email them and ask to buy/sell a bond. Like in olden times when you wanted to see your friend and you called them!

The person on the phone is called a broker. The broker offers a price and the investor either says “good deal,” or “no thanks.” Different brokers will sometimes offer different prices, and investors will shop around for the best deal.

Since the average person doesn’t have a bond broker, the easiest way to invest in bonds is through a mutual fund or bond ETF. If you want to buy government bonds, you can buy these directly from the US government.

RECAP

Bonds are like loans for companies or governments. They offer fixed payments called coupons. Interest rates affect their prices and yields. When prices go up, yields go down.

Credit rating agencies assign grades to bonds that rates how good the company or government is at paying back their debt. These grades also affect the price.

Regular investors can buy bonds through bond mutual funds or bond ETFs. Or purchase US debt directly from the government.

Bonds are less risky than stocks because they offer fixed payments. Company growth doesn’t matter – as long as the issuer consistently makes enough money to pay back their debt, the bond will give the investor a positive return.