Bonds are essentially a form of IOU between the borrowers and the ledger. They serve as an alternative debt instrument and are loans taken out by companies and governments.
Investors who lend the capital to the borrower receive an interest coupon, the annual rate of interest paid on a bond. Coupon rates are expressed as a percentage of the principal amount, also known as the “face” or “par” value.
Upon maturity, investors get back the principal amount.
How to Buy Bonds on Stock Exchange
Investors can consider two general categories when looking to invest in government bonds: Treasury bonds and municipal bonds. Both provide a low-risk way to build your portfolio or save money at higher rates.
The U.S. Treasury has made it easier for U.S. investors to purchase Treasury bonds by offering them on TreasuryDirect. Account-holders can participate in the auctions conducted several hundred times per year.
Bonds can have a wide range of moving parts, and the primary market is tough to evaluate for most investors.
The secondary market has less transparent pricing than primary issues, making it difficult for individual investors to know the true cost of bonds and how much markup is built into the cost.
Bond mutual funds are a great option for investors looking for a more cost-effective way to gain exposure to the bond market than buying individual securities. Bond funds allow you to pool your money with other investors and buy shares of a portfolio of bonds.
Bond funds may be actively or passively managed, and they tend to pursue a particular maturity strategy—long term or short term.
How Bonds Perform in Different Economic Cycles
Before investors decide to move forward with their investment decision to buy bonds directly or through ETFs, it is important for them to understand how the asset class performs during different economic cycles. It is important to understand the relationship between bond prices and interest rates and how bonds react in different environments.
Interest Rates and Bond Prices have an inverse relationship and tend to move in the opposite direction. With this in mind, we can look at various scenarios and how bond prices are impacted:
Inflationary Environment
When inflation is persistent in the economy, the central banks need to keep raising rates to bring it under control. As rates rise, bond prices start to drop rapidly. Let us look at an example to understand this phenomenon.
Say you own a bond with a face value of $1,000 and a coupon rate of 2%. If interest rates are increased, the government or corporations will issue new bonds with higher coupon rates. Let’s say the new bonds have a 3% coupon rate. Investors will want to buy them instead of your 2% bond.
The market price of your bond will fall until it matches 3% at par with the new bond. This means you would sell your bond for $666 to compensate investors for a discount in the rate compared to the new prevailing rates.
While bonds have historically been resistant to downturns in the periods of interest rate increases, loose central bank policies that have kept rates low at near zero for the better part of the decade have made bonds volatile and just as vulnerable to a selloff as equities.
Deflationary Environment
When the economy sees Deflation or negative growth, Central Banks start cutting rates to increase borrowing activity in the economy, which in turn leads to an increase in bond prices.
Suppose that interest rates decline. If you already own a 2 percent bond, it will become more attractive to prospective investors and increase the value until its effective return equals 1 percent.
Thus, the existing bond will start trading at a new price of $2,000. Bond markets have continued to grow over the last five decades, driven by central banks, which have cut rates from over 20% to under 2%.
Eurobonds and yen-denominated bonds have fared better since rates have slipped into negative territory in recent years.
Stagflationary Environment
Stagflation is a combination of economic factors that occurs when economic growth slows, demand falters, unemployment rises—and almost contradictorily, inflation keeps climbing.
This situation occurred in the 1970s and is currently happening today. Bonds could underperform as high inflation, tightening fiscal policy from the central bank, and increased bond issuance to fund investments could push yields higher, resulting in a sharp drop-off in existing bond prices.
Understanding the Yield Curve Inversion
Investors generally tend to look at interest rates rather than the yield curve when gauging the debt & equity markets.
The yield curve describes the relationship between the yield for similar bonds with different maturities. However, investors need to take notice of the yield curve when it inverts. When this phenomenon happens, the yields earn on short-term bonds surpass those of long-term bonds.
This is notable since, all things being equal, bonds with longer maturities need to typically pay higher interest rates. This is done to compensate investors for the additional duration risk.
However, over the past year, the treasury yields on the 2-year have moved higher than that of the 10-year, indicating that recession may be imminent.
Put simply, when the yield curve inverts, investors collectively see more risk soon than over the long term. This can be explained with an example, as it is important to look at what happens in the banking system when the yield curve inverts.
Generally speaking, the yield curve measures the spread (profit) that a bank makes by lending out money versus its own cost of borrowing. When banks can’t make money because the spread between interest rates is too small, they lend less and economic activity slows.
While the yield curve is reliable about impending recessions, it often has a time lag, with other signals such as an increase in unemployment and a slowdown in manufacturing data being key indicators.
For instance, the yield curve inverted 422 days ahead of the dot-com bubble, 571 days ahead of the 2008 housing crisis, and 163 days before the recession caused by the pandemic.
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