We just have a quick question here from Sakeem, asking for more information on bonds, bond prices, bond yields and how all of this comes back to the risks done on a daily basis.
So what we can do for this Sakeem, is lets just take a quick step back and look at bonds in a bit more detail. When we normally talk about bonds, we are referring to government bonds. And the reason of course, why governments would issue bonds in the first place is because they want to raise capital.
So we have the US government, for example, they need to raise money, so they issue new government bonds in order to borrow money from willing lenders, which are those who buy the bonds, but of course, they need to pay you something for lending them the money, right.
So, they will give you an interest payment, some interest on that. Now, when you buy a bond, lets say you buy a government bond for $1,000 at par value, you also get what is called a coupon and that is normally the fixed interest payment from the government as an interest for borrowing them the money. So imagine that you buy a bond at an interest rate of 3% That would mean that you get paid $30 every year in interest for the thousand dollars that you’ve lend to the government.
Now you can calculate the yield for that bond by simply taking the coupon payment, which is $30. So let’s take $30, and you divide that by the price that you paid for the bond, and that’ll give you your 3% yield. So from this, you can see that there is an inverse relationship between bonds and their yield. So if, for example, let’s say you bought that same bond at the same interest rate, but you bought it for 1100, for example, so you have the same coupon payment of 30. But you buy it for 1100. That’ll give you a much lower yield. So when the price of the bond goes up, the yield goes down.
The same will be the case if the price goes down. So we have that same coupon and remember, the coupon rate is important because the coupon payment never changes for the life cycle of the bond. So you’ve got your same $30 but now somebody buys it from you at a lesser price. So, you paid 1000, but you sell it for 900.
Now, the yield for that particular bond will be three bucks, about 3%. So, you can see that inverse relationship between the price of the bond and the yield of the bond and the way that you can calculate that is by looking at the interest rate that was locked in when that bond was bought. So, the coupon rate, right?
Now, this is important because, bonds can be traded in both the primary and the secondary market. So, once a bond has been bought and issued for the first time, so, let’s say you’re that first buyer of that bond for the thousand dollars, after that, that bond can be traded like any other asset in the secondary market, and bonds will be bought and sold for many different reasons based on the quality and base on the economy.
The first one is quality. So, what is the quality of the bond? If it’s a triple A rated government bond like a US bond, for example, that is considered to be a very safe investment because the US has a very slim chance of defaulting on their debt, right? Compare that to a country like Venezuela, for example.
If you want to buy a bond from them, they will need to offer you a much higher yield, because you basically need to, you’re taking the risk on lending them that money and you might not get that money back. So they need to offer you a more attractive coupon rate a more attractive yield for you to buy that bond. Another thing to keep in mind apart from the creditworthiness is the actual economic climate for a government bond, right.
So what are the expectations of rising and falling interest rates. So a triple A rated government bond from the US is considered as one of the safest investments that money can buy, because the default risk is very low.
So when bond investors think that the economy is slowing, they will start accumulating bonds from a safe haven point of view.
Now the increase in demand for those bond purchases pushes up the bond price. And thus obviously pushes down the bond yields. So the expectation of a slowing economy means that the market will start to eventually expect lower interest rates from the Federal Reserve, right? Which is another reason why bond holders essentially the bondholders that wants to buy and hold like a pension fund, if they know that or they think the economy is going to slow, they would like to buy bonds while the interest rate is still attractive.
For example, if you are that pension fund buyer, then buying the bond when the cycle starts to slow means that you can lock in a much higher yield or a much higher coupon for that particular bond based on where the interest rate is. And of course, the more investors that buy at that lower prices, the more the demand will rise. And of course, the more demand rises, the price rises and so the yield goes down. So going back to that bond example of $1,000 and 3% yield or coupon, right, if you bought it at $1,000 at 3%, your coupon payment will stay $30 until the bonds lifecycle is complete.
Now imagine that interest rates suddenly go up with 1%. So you bought it at 3% yield but now suddenly, in a year’s time, interest rates are at 4%. Okay, so if you would want anybody to buy that bond, you can’t, you can’t get the same money that you paid for it right, you would need to offer them that lower price. So you would need to offer them that, if it’s 3% and 4%, you would need to offer them 750 for that bond, just in order to get the same yield that they can get for a new bond in the market.
So that is how the bond price obviously in the secondary market, how things like interest rate expectations changes, why they want to sell and buy bonds, as the interest rate obviously affects what they can get in terms of yield. So it makes sense for them to buy when the yields are high, because then obviously, you have a much better chance of selling those bonds at a higher price as the interest rate starts to go down.
Now if you’re an investor that just wants to rotate temporarily out of stocks and into bonds, then buying them as a safe haven asset obviously makes sense. But importantly in both cases, whether you buy it as a long term investor or you just buy it to rotate out of riskier assets, the important thing is that as the bond prices goes up, the yields are expected to go down and vice versa. So bond demand usually goes up when the economy is expected to slow. And that means that the yields are expected to fall and bond demand usually goes down when the economy is expected to rise and that obviously leads to a rise in the yield as well.
So, when we consider this from a more intraday perspective, rising bond prices or lower yields are normally indicative of risk-off flows and falling bond prices are rising yields are normally indicative of risk-on flow.
So in today’s session, for example, we’ve seen bond yields move lower. So obviously, if we go to our Zenith platform, we can see that bond prices are green. So bonds are in demand as a safe haven, which means that the yield should go down. So we’re seeing that inverse relationship and because yields are moving down, normally a sigh of risk-off, we can just correlate that to other markets are equity markets moving down?
Yes, they are, are commodity markets moving down? We can see, let’s just go to a more intraday view. Commodity markets WTI, Brent Crude coop are all moving down. So that’s obviously indicative of that risk of flow. Now something that also affects bond prices, especially at the back end of the curve.
So your 10 year yield, or your 10 year bond and up, is inflation. So remember if you bought and that same bond of $1,000, right at that 3% yield, but inflation is expected to rise in the next few years that makes your bond less attractive because if inflation itself reaches 3%, you know, in the next few years, then your yield, that 3% yield will drastically diminish as you will basically only get the price that you paid for the bond back, you’ll only get, you’ll still get that thousand dollars, but that thousand dollars is gonna be worth a much, worth much less because the future value of money goes down.
So what usually happens to the bond market with inflation data and inflation expectations are bond yields usually rise when inflation expectations rise as investors will rotate out of bonds, meaning less demand, prices fall and into higher yielding assets like stocks, etc. So that is what happened last week, for example, we saw that huge run up to the upside in terms of bond yields as people got rid of bonds and started to rotate into riskier assets like equities, etc.
So what usually happens to the bond market is not only based on its creditworthiness, not only based on the economic cycle, but also very linked to inflation at the more back end of the curve, 10 years and upwards.
Now alternatively, what some investors would like to do is they still want to keep their risk low by not investing necessarily in equities, but they can keep, they still want to invest in treasuries, but what they can do is they can buy something like inflation protected bonds, which is something called TIPS.
Now if we go to gold for a second and just go to a higher timeframe, gold is also considered as a safe haven, right and also considered as a classic inflation hedge. So what you’ll normally see happen is you’ll normally see gold correlated very strongly with inflation protected securities, which is TIPS.
So it’s going up for the same reason as bonds, but it might follow TIPS more closely because it’s also considered as a more inflation hedge compared to something like just regular treasury bonds.
So, Sakeem, I hope that helps with your question giving you a little bit more context on exactly how we relate back to bonds and bond prices and bond yields and how of course that relates back to the overall risk done. Any other questions, don’t hesitate to let us know.