Can you explain bonds to me?
I like to think of bonds as a type of loan. Let's take the perspective of a buyer (just in case you are thinking of purchasing some). When you purchase a bond, you are effectively lending your money to the entity selling the bond. Now, the seller of the bond has to compensate you the buyer in some way because why would you lend your money for free? So in addition to returning the original money you loaned out called the face value, you receive additional payments every year called a coupon which is set at some fixed percentage relative to the face value. So let's say you loan someone $100 at a coupon rate of 5%, the $100 is the face value and the $5 you get paid every year is the coupon. That face value of $100 is then returned to you at the end of the agreed upon time period, which is referred to as the maturity date.
How is this not just free money?
Whenever you invest in something, the first thing you must understand is the risk you are taking. A useful way to think about it is that potential profit is proportional to risk. What that means is the more risk you take, the more money you stand to gain. So what risks are you taking when you purchase bonds? Here's a couple: - They might not pay you back. There's always a chance of nonpayment, even if the entity you are lending to is the United States Government. - Opportunity cost. When you lend someone your money, you can no longer use it. During that time, another investment or asset could end up being a better opportunity, meaning you miss out on the returns you could have earned elsewhere. So the lesson is, there is no such thing as free lunch, do your research and be aware of the risks.
The whole idea of these financial systems and products is to allocate money to those who need it the most, by incentivising those with extra money to lend out their cash.
How do I know if it's a good deal?
Because bonds are essentially a series of cash flows (it might be useful to think of money or cash as a liquid which can flow in and out of places), you price bonds based on the present value of said cashflows (money now is worth more than money later, so to value receiving $100 5 years later you would convert it to today's value, the process of which is called getting the present value). Now, the price you end up getting might differ based on certain assumptions, but I think the intuition for what happens to bonds is a lot more important. It all comes down to how much you think the money you receive from the bonds is worth, and whether you are willing to pay the market price for it.
What happens to my bonds if [you can insert any event here] happens?
You can't adjust the coupon even though market conditions change so the mechanism by which bonds “adjust” compensation is by price changing. So in addition to the face value and the coupon, you have the price of the bond. Now this gets a little confusing because a bond might have a face value of $100, but you do not always pay $100 for it. You might pay $105, $100, or $70 depending on market conditions.
Going back to the analogy, it's as if you loaned me $70 and in return I will pay you $5 per year and $100 when the agreement ends. In this analogy, the $70 is the price of the bond, the $5 is the coupon and the $100 is the face value. So the big takeaway is that the price of the bond is not always equal to the face value, although it is much easier to intuitively understand bonds in cases where they are equal.
Let's say interest rates rise, what happens to bond prices? Well if there is a better opportunity, why would I buy bonds? So, you must compensate me more so that I might consider purchasing said bond. Because the face value and the coupon cannot change, you make the bond itself cheaper. I might not want to buy a bond with a coupon of $5 and a face value of $100 if it costs $105, but if it costs $70? Now that's a whole other story…
So from now on if something happens in the market, ask yourself: “Would I need to be paid more to want to buy bonds?” If yes, then the price of bonds will fall. If no, then the price of bonds will rise.
I still don't get it…
Ok fair point, lets go through a few examples to build your intuition about bonds and lets not worry too much about the details and perhaps that will help.
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People are panicking in the market and want “safer” assets -> Higher demand for bonds -> Prices rise
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Stocks are not doing well -> Bonds become more attractive as an investment -> Prices rise
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Stocks are doing fantastic -> Bonds become less attractive as an investment -> Prices fall
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The person you are borrowing from might not pay back -> I must be compensated more for taking this risk -> prices of bonds fall
Here's an interesting one, what happens if oil prices go up? This causes the price of everything to go up (inflation) since oil is used to transport things and as a source of energy (the cost of producing anything will rise). Prices going up means that money is worth less in the future, which means I should be compensated **more **for lending my money, which means bond prices will fall.
*This article is not meant to be an end all be all guide to bonds, it is only meant to explain bonds in the simplest way I can conceive. In other words, none of this is financial advice and you should do your own research.
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