Today’s topic is,
‘If bonds are safe assets, why do their prices fall?’
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Bonds seem safer than stocks. However, when interest rates rise, bond prices can fall. Understanding this will significantly change how you view government bonds, bond ETFs, LQD, and more.
The keyword for this time is,
‘Interest rates and bond prices move like a seesaw.’
.
When you start investing,
the topic of stocks
comes up quite early.
All Country.
S&P 500.
High-dividend stocks.
Individual stocks.
And,
as your studies progress a bit,
the term
‘bonds’
comes up.
Smaller price fluctuations than stocks.
Defensive assets.
Used for diversification.
Seeing descriptions like that,
I initially
thought:
‘Are bonds basically like savings?’
But,
when you look at a bond ETF chart,
they are clearly falling.
10%.
20%.
In some cases,
they can fall even more.
‘Aren’t they safe assets?’
you might think.
Actually,
bonds have
a very important mechanism that beginners often stumble over at first.
That is
the relationship between interest rates and bond prices.
Once you understand this,
your perspective on bonds
will change completely.
For example,
let’s consider a very simple bond.
You lend 1 million yen.
Every year,
you receive 10,000 yen in interest.
In other words,
1% per year.
After a few years,
the 1 million yen will be returned.
Suppose you held such a bond.
However,
the following year,
market interest rates rise,
and for newly issued bonds,
you can get 30,000 yen annually
for 1 million yen.
In other words,
you can now get 3% per year.
Now then.
If you were someone buying a bond
starting now,
which would you want?
A bond that pays 10,000 yen annually.
A bond that pays 30,000 yen annually.
Of course,
if the conditions are the same,
you’d want the one that pays 30,000 yen.
Consequently,
the old bond issued at 1%
becomes harder to sell
at 1 million yen.
‘If I’m going to pay 1 million yen,
I’ll just buy the new 3% bond.’
That’s what people will think.
So,
how do you get someone to buy the old 1% bond?
You need to lower the price.
This is
the fundamental reason why bond prices fall.
In other words,
interest rates rise.
The appeal of new bonds increases.
The appeal of old, low-interest bonds decreases.
As a result,
the price of old bonds falls.
This is the relationship.
Therefore,
in the world of bonds,
it is often said,
‘When interest rates rise, bond prices fall.’
. The reverse is also true. For example,
you hold a bond that pays 3% interest.
But,
new bonds in the market
only pay 1%.
Then,
the 3% bond you hold
becomes attractive.
More people will say,
‘I want that.’
As a result,
the price tends to rise.
In other words, interest rates and bond prices basically move in opposite directions.
It’s a seesaw relationship.
If interest rates rise,
bond prices fall.
If interest rates fall,
bond prices rise.
Of course,
in the actual market,
there are other factors like credit risk and supply and demand.
But,
for now,
just understanding this seesaw is enough.
Here,
a question arises.
‘But if I hold it until maturity,
won’t I get the 1 million yen back?’
That’s correct.
This is
a very important point
when considering individual bonds
versus bond ETFs.
For example,
you hold a bond with a face value of 1 million yen, and the issuer can repay it properly.
And,
you don’t sell it midway, but hold it until maturity.
If you do that,
even if the market price drops to 900,000 yen along the way,
there are bonds designed to return the full face value at maturity.
In other words,
the price drop along the way
is not realized unless you sell.
Looking at this alone,
it’s a bit different from stocks.
However,
when it comes to bond ETFs,
the story changes a bit.
Bond ETFs
do not just hold one bond until maturity and then end.
They hold many bonds,
and continue operations while replacing those nearing maturity.
Therefore,
the ETF itself does not have a single maturity date
where it says, ‘It will return to $100 on this day.’
This is something
you want to know as a beginner.
For example,
US bond ETFs.
Corporate bond ETFs.
Investment-grade corporate bond ETFs like LQD.
Such products
invest in bonds.
But,
unlike bank deposits, the principal is not fixed.
If market interest rates move,
the price of the ETF also moves.
In other words,
it’s not the case that ‘prices don’t move because they are bonds.’
That is what it means.
So,
how much do they move?
That’s where
a somewhat interesting term comes in.
‘Duration’
.
Just looking at the name,
it seems incredibly difficult, right?
But,
first,
it’s okay to understand it quite simply. Duration is, roughly speaking,
a number used to see ‘how easily this bond’s price fluctuates when interest rates move.’
For example,
suppose the duration is
about 8 years.
To simplify it greatly, when interest rates rise by 1%,
the bond price
could potentially fall by roughly 8%.
Conversely, if interest rates fall by 1%,
it could potentially rise by roughly 8%.
It’s used with that kind of sense.
Of course,
in reality,
it doesn’t happen exactly like this.
But,
for beginners to look at risk,
it’s quite useful.
In other words,
the longer the duration of the bond,
the more sensitive it is to changes in interest rates.
That is what it means.
Here,
there is something interesting.
With bonds,
generally, the longer the period until maturity, the more susceptible they are to interest rate fluctuations.
Why is that?
For example,
a bond that only pays 1% per year.
Maturity is in six months.
If so,
if you endure it for a little while, it will be over.
Even if interest rates rise,
the period of being affected is short. But,
for the next 20 years, it’s 1% per year the whole time.
On the other hand,
new bonds are 3%.
If so,
there is quite a difference.
In other words,
the longer you are tied to old conditions,
the greater the impact when market interest rates change.
Therefore,
the longer the bond,
the greater the price movement tends to be.
Thinking about it this way,
duration also
becomes a little easier to understand.
Since I understood this,
the meaning of the phrase ‘Bonds = Defense’
also
changed a little.
Because it’s defense,
it absolutely won’t fall.
That’s not it.
Rather,
it’s easier to think of them as assets that move for different reasons than stocks.
For example, the economy worsens.
Interest rates fall.
Then, some bond prices may rise.
There are times when bonds support you
when stocks are weak.
That’s why
they are incorporated into a portfolio. This also connects to the
‘correlation’ story I wrote before.
Diversified investment is not about having a lot of things.
It’s about having things that move for different reasons.
Stocks.
Bonds.
Cash.
Each
has a different reason for moving.
That’s why
there is a point in combining them.
However,
even here,
‘All bonds are the same’
is not true.
Government bonds.
Corporate bonds.
Short-term bonds.
Long-term bonds.
High-rated bonds.
High-risk bonds.
All of them
have different characteristics.
For example,
corporate bonds.
These are bonds where you lend money to a company.
Compared to government bonds,
there are some that can expect higher yields.
But,
in exchange for that,
there is credit risk
that the company may not be able to repay.
In other words,
there is a reason
for high yields.
This is a bit similar to stock dividend yields.
The yield is high.
Therefore,
it’s absolutely a bargain.
That’s not it.
‘Why is it high?’
Look at that.
This is
also important for bonds.
For example,
a certain bond is
6% per year.
Another bond is
2% per year.
Looking only at the numbers,
6% is overwhelming.
But,
if the reason it’s 6% is
‘because there is a high possibility it won’t be repaid,’
then the story changes.
In investing,
it’s basically hard to expect
that only high returns
are placed there for free.
There is some kind of
risk.
Therefore,
when looking at bonds,
not just yield,
but interest rate risk,
credit risk,
and duration
should be looked at.
This becomes important.
Furthermore,
bonds have
interesting numbers that are different from stocks.
For example,
yield.
With bond ETFs,
not only distribution yield,
but also SEC yield and other numbers
may appear.
Then,
beginners
will wonder, ‘Which one should I look at?’
But,
even here,
what’s important is
not to decide good or bad
based on a single number.
The yield is high.
But, the price has fallen significantly.
Or,
credit risk has increased.
Such things also happen.
Therefore,
even with bonds,
‘yield’ and ‘price’ must be looked at separately.
For example,
you get 30,000 yen per year from a 1 million yen bond.
Yield is 3%.
That bond price
fell to 800,000 yen.
If it’s the same 30,000 yen,
relative to the current price,
the yield looks higher.
In other words,
as a result of the price falling,
the yield may have risen.
This is
similar to high-dividend stocks.
The dividend is the same.
Only the stock price falls.
Then,
the dividend yield becomes higher.
Therefore,
‘Higher yield = good news’ is not necessarily true.
This is
common to both bonds and stocks.
I,
the more I learned about bonds,
the more I came to think that in investing,
one should be a little careful
with the word ‘safe.’
Safer than cash?
Safer than stocks?
Principal guaranteed?
Small price movements?
Low bankruptcy risk?
Based on what criteria
are you calling it safe?
If you don’t look at this,
the meaning changes. For example, individual government bonds.
Bond ETFs.
Both are
‘bonds.’
But,
their characteristics
are quite different.
Even among peers with the same name,
price movements.
Midway liquidation.
Interest rates.
Maturity.
Credit risk.
Each is different.
In other words,
in investing,
do not judge by category name alone.
Look at the contents.
This is
the same for investment trusts,
high-dividend stocks,
and bonds.
And,
the two things I want you to remember most today are these.
First,
‘When interest rates rise, bond prices tend to fall.’
And,
one more thing.
‘The longer the bond’s period, the more susceptible it tends to be to interest rate fluctuations.’
Just knowing these two things
will make it less likely that when a bond ETF falls,
you’ll think, ‘Why, even though it’s a bond?’
Rather,
‘Ah,
because interest rates rose,
long-term bonds are being affected.’
You will be able to think of the reason.
Just this alone
will change how you view investing
quite a bit.
I used to think stocks were offense,
and bonds were defense.
But,
in reality, it’s a bit more complex.
Stocks are assets that receive corporate growth.
Bonds are
assets that lend money and receive interest.
Cash is
an asset that can be used immediately.
Each
has a different role.
And,
because they have different roles,
there is a point in holding them together.
In other words,
diversified investment
is not ‘collecting a lot of safe things.’
It is combining assets with different risks.
Stocks fall.
Bonds,
in some cases, also fall.
But,
the reasons for falling are different.
Using that difference,
you build the entire portfolio.
Once you understand this far,
yesterday’s ‘correlation’ and
the day before yesterday’s ‘rebalancing’ stories
will also connect quite well.
What to hold.
How much to hold.
How each moves.
And,
if it deviates, adjust it.
Investing is
not a game of guessing one product.
It’s a game of combining money with different personalities to create a team you can continue with.
I
think that if you think about it that way, the portfolio becomes much easier to understand.
Next time,
when you look at a bond ETF.
Even if the price has fallen,
don’t immediately think, ‘It’s a bond, so it’s no good.’
Try thinking this way once.
‘How are interest rates moving now?’
And,
one more thing.
‘What is the duration of this bond?’
If you know these two things,
the reason for that price movement
will become visible little by little.
Investing is
not about memorizing a lot of numbers.
It’s about understanding ‘why it became that number.’
If that increases one by one,
even when you see a product you don’t know,
you will be able to think for yourself.
Bonds, too,
seem difficult at first.
But,
the entrance is one.
Interest rates and bond prices are a seesaw.
First,
just remember this.
From there,
yield.
Duration.
Credit risk.
Little by little,
increasing your understanding is enough.
Asset formation
does not need to be learned all in one day.
Today,
you learned one more word than yesterday.
Even just that,
as an investor,
I think you are properly moving forward.
Thank you for reading this far!
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May your investment journey be calm and certain.