“US Treasury bonds were sold off, and long-term interest rates rose.” When watching stock market news, this type of explanation often appears. Even though the topic was supposed to be interest rates, now it’s said that bonds were sold. How are bonds and interest rates connected, and why do even those who watch stocks care about the bond market?
Bonds are issued by national governments, local public entities, corporations, and others to borrow money from investors. If issued by a government, they are called government bonds; if issued by a corporation, they are called corporate bonds. While the name sounds difficult, they are basically like IOUs that specify “when interest will be paid and when the principal will be returned.”
Suppose a fictional company issues a bond with a face value of 1 million yen, a 2% annual rate, and a 5-year maturity. If these conditions are fixed and interest is paid once a year, the interest the investor receives is 20,000 yen per year. At maturity after 5 years, if the issuing company pays as promised, the 1 million yen face value will be returned. This is a simple example that does not consider taxes or fees.
Three terms for reading bonds appear in this example. “Face value” is the amount that serves as the basis for interest calculations and redemption at maturity. “Coupon rate” is the percentage of the face value paid as interest. “Maturity” is the deadline for returning the principal. The 2% coupon rate is determined based on the face value, regardless of what price the bond is trading at in the market.
From the perspective of the bond issuer, it is a way to raise a large amount of funds at once. Governments raise funds necessary for policy, while companies use them for capital investment, business funds, or repaying previously raised funds. In exchange for lending money to the other party, investors receive interest and principal according to the set conditions.
The difference from stocks also lies here. Buying stocks means investing in a company and becoming a shareholder. If the company’s profits increase, there is a possibility of obtaining significant results in the form of increased dividends or rising stock prices, but dividends and future stock prices are not promised. On the other hand, those who buy corporate bonds are not owners of the company, but lenders. Even if the company grows significantly, the interest received or the redemption amount does not automatically increase in principle.
Some bonds are traded on the market after they are issued. This is where it looks different from a bank deposit and is hard to see. Even if you buy the aforementioned bond for 1 million yen, it is not guaranteed that you can sell it for 1 million yen midway. If the market price is 950,000 yen, the amount received from selling it is 950,000 yen. Conversely, it can also be traded at a price exceeding 1 million yen. The result differs between holding until maturity and selling midway.
“Coupon rate” and “yield” are also not the same. Even if the aforementioned bond continues to pay 20,000 yen in interest every year, if the market price is 950,000 yen, the ratio of one year’s interest to the purchase price is approximately 2.1% by simple calculation. This is one way of looking at yield. If you consider the yield when holding until maturity, the difference between the purchase price and the face value, as well as the time until maturity, are also involved.
The “government bond yield” moving in the news does not mean that the coupon rate set at the time of issuance is being rewritten every day. As bond prices move in the market, the yield calculated from that price also moves.
So, why do bond prices change? There are various factors such as market interest rates, the period until maturity, the creditworthiness of the issuing country or company to repay, the outlook for prices, and supply and demand for trading. If other conditions are the same, when market interest rates rise, the price of already issued bonds generally tends to fall. We will verify this mechanism using numbers next time.
It is also dangerous to just remember that “it is safe if you hold until maturity.” There is credit risk that the issuing company or others may not be able to pay interest or principal. Even if you receive fixed interest, if prices rise significantly during that time, what you can buy with the money you receive will decrease. Even if you try to sell midway, you may not find a buyer at the desired price. If it is a foreign bond, the exchange rate when converting to yen also affects the result. The risks involved differ depending on the type and conditions of the bond.
For those who watch stocks, the bond market is not a distant place. Government bond yields are involved in the “standard for replacing future profits with current value” that we looked at last time, and the yield that investors compare with stocks. The yield and price of corporate bonds can also reflect the conditions under which companies raise funds and the market’s view on repayment ability.
Changes in the bond market do not necessarily precede stock prices, but they serve as material to verify views on interest rates and credit from a place separate from stock prices.
When reading bond news, I would like to first check four things. Who is borrowing the money? When is the maturity date? Am I looking at the coupon rate at the time of issuance or the current yield? And why did the price or yield move? I do not decide the impact on stocks based solely on the sentence “government bonds were sold,” but trace the views on interest rates, the economy, prices, and credit that lie between them.
Bonds are a mechanism for countries and companies to borrow funds and for investors to lend them. And the prices and yields created in the bond market reflect various views of the financial market. Movements that were not visible when looking only at stocks gradually become connected by knowing about bonds.
Next time, “Why do bond prices fall when interest rates rise?” We will use the 1 million yen bond from this time again to look at the reason why interest rates and prices tend to move in opposite directions.
Reference Materials
Ministry of Finance “Did you know? Government Bonds”
https://www.mof.go.jp/jgbs/individual/how_to/index.htm
Japan Securities Dealers Association “(Bond) Yield”
https://www.jsda.or.jp/shijyo/seido/jishukisei/words/0277.html
Japan Exchange Group “Let’s think a little about future money”
https://www.jpx.co.jp/tse-school/learn/07.html
Investor.gov “Bonds – FAQs”
https://www.investor.gov/introduction-investing/investing-basics/investment-products/bonds-or-fixed-income-products/bonds
Investor.gov “Corporate Bonds”
https://www.investor.gov/introduction-investing/investing-basics/investment-products/bonds-or-fixed-income-products
Disclaimer
The content of this article and this account is intended to provide information for learning about finance, the economy, and market mechanisms. It does not recommend the purchase or sale of specific financial products and does not provide investment advice. It does not guarantee future market trends or investment results. Please make investment decisions at your own responsibility.
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