Up or Down??

It is often said that what goes up must come down. But what if something can go up AND down at the same time? Well, in the world of bonds it can happen.

Most people only look at one side of the bonds – yield, or rate. Mortgage brokers specifically will tell you rates are up, so that must mean up is up, right? Well, not really. It truly depends on what side of the bond you are on. Let look a little closer.

Bonds are one of the most important markets in the world. The bond market, whether it be US Treasury bonds, Municipal bonds, or any bond all combine to make the second largest tradeable market in the world – second only to currency markets. What the bond market does matters, and it can truly shape the financial world we live in. The bond market is a great predictor of what the future holds and is a far more reliable fortune teller than stocks, housing, or commodities.

I have received a lot of questions lately surrounding how bonds work ,and how they affect mortgage brokers lives, so let’s take a peek, shall we? Fair warning to any bond professionals that follow this blog – I am going to make this a very simple example so everyone can understand. I am going to use a very standard Canadian Government bond in my example to make things easy.

Bonds have basically 2 components to them – the principle lent, and the interest rate paid. In our example the Canadian government needs to borrow money, they create a bond – which is effectively a promise to pay. Someone lends the government money for a set amount of time, and the government promises to re pay the full amount lent, plus interest. There are 2 main things a bond investor has to worry about. First and foremost the bond investor has to be confident they get their money back at maturity. If I loaned the Canadian Government $1,000.00 today, would they re pay me my principle 5 years from now? With most governments in the developed world, the answer is YES. Federal governments especially have the ability to issue debt almost at will – as we learned during COVID. They can issue debt to re pay debt, and can raise taxes to ensure enough funds to re pay investors. For Canadian and US Governments, this is usually not a large concern. Now, if I was investing in Argentina government notes, this may be a problem, as the chance of me getting my original investment back is in question. The second component to the bond investment is the interest rates, more commonly referred to the yield. What rate will I be paid to loan money to the government? If I am loaning my money to the government for 5 years, I need to make sure that when I get back my initial $1,000.00 I have earned a return, otherwise I will have lost money in real terms with inflation factored in. $1,000.00 today at zero interest is maybe only worth $900.00 in 5 years in purchasing power. So, I have to be paid something to ensure that my $1,000.00 maintains purchasing power, and I get paid some return on top of that.

Okay, so we know the 2 components that go into bonds, lets look at the inner workings. If I purchased a bond today for $1,000.00 and the interest rate was ( for easy math ) 5.00%, this means that I would be paid $50.00 a year in interest. After 5 years, I would have earned $250.00 in interest ( $50.00 a year x 5 years ) and I would get my $1,000.00 back. Okay cool. This works if an investor buys and holds a bond for the duration of 5 years. However, many investors do not do this, and rather trade bonds. Pension funds, hedge funds, mutual funds etc. all trade bonds daily. As we know, the interest rates move hourly based on news, data, and assumptions about the future. Herein lies the issue with a bond.

If interest rates were to rise from 5.00% to 5.50% we would have an issue. Why would anyone buy my $1,000.00 bond from me that pays 5.00%, when they could go into the market, and buy a newly issued bond that pays a 5.50% interest rate? At 5.50%, the same $1,000.00 bond now pays $275.00 in interest to the holder, instead of the $250.00 that my bond pays me at 5.00%. I would now be stuck with my bond for 5 whole years until it matured and the government gave me back my $1,000.00. Or would I?

In todays bond market, the ability to trade bonds is everything. So, the only way that someone would buy my bond is if they could earn the same return over the course of the 5 years as they could earn by purchasing todays higher yield bond. To counteract this, the price of the bond must change. If I sell my $1,000.00 bond for $975.00, then the $975.00 the investor pays for the bond, plus the 5% yield they earn on the $1,000.00 is the same as spending $1,000.00 on a new bond at 5.50%.

The reverse is also true. If I have my $1,000.00 bond at 5.00%, and yields fell to 4.00%, I could now sell my $1,000.00 bond for $1,050.00. Since my bond pays interest for the next 5 years at 5.00%, and newly issued bonds would only pay 4.00%, the extra $10.00 a year in interest is something an investor will pay for. Of course there is a myriad of factors like coupon rate, yield to maturity, compounding periods, yield to call, etc. etc. that go into pricing. I am trying to make it as easy as possible to understand.

In todays ever increasing interest rate environment we keep hearing that bonds are ‘ up’ when it could be the opposite. When yields ( interest rates ) are up, then the price of the bond is down. Bond prices have dropped quite substantially since March of 2022 ,and are on track for one of their worst track records since the late 1970’s. As yields continue to rise, bond prices will continue to fall. This is a double whammy for someone who has owned bonds for a few years. They have a poor yield on the bond, plus the market value of the bond is dropping based on todays higher rates. Think of someone who bought a Canadian Government 5 year bond at the lows of 2021 at around .60%, when todays 5 year government is around 4.255%.

While interest rates rising may be a problem, the drop in value of the bond itself is also a major concern for a lot of owners of bonds. Who is one of the largest owners? Canadian Banks. As bond prices drop, they must set aside more capital against dropping prices, which in turn leads to needing higher margin on funds they loan out on new mortgages – and around and around we go.

Yield up, means price down, and yield down means price up. What goes up can most certainly come down, but what goes up may also be down.