The Lazy Economist: The beautiful, bountiful world of bonds

The simple investment vehicle you should know about

Bonds are a vehicle for saving.

If you aren’t familiar with investing, but want to save a few hundred dollars for a post-grad trip, a future shopping spree, or that scary thing people call “the future,” bonds are a great thing to know about.

In short, bonds are a vehicle for saving. They are sold by governments and corporations as a way to borrow money. When someone buys a bond from either, they get their money back at an agreed-upon “maturity date.”

The owner of the bond also receives interest payments along the way, which are called “coupon payments.” For example, say someone buys a $1,000 bond with a five-year maturity and a four per cent annual coupon rate. They will receive $40 every year in interest, and get their $1,000 back at the end of five years. The money a bond generates for the person who buys it is called a “yield.” 

Although this isn’t always the case, bonds can often be bought and sold once they are issued.

An important fact about coupon rates is that they tend to change along with all the other interest rates in the economy. If interest rates go up, the coupon rates on new bonds typically go up. Conversely, if interest rates fall, new bonds will tend to offer lower coupon rates.

These fluctuations might lead to problems for investors. Say, for example, that I buy that five-year $1,000 bond at the four per cent coupon rate. After I buy it, however, interest rates rise, and you can now get a five-year $1,000 bond with a six per cent coupon rate. People who want to buy bonds can get a better deal by purchasing new bonds. This can be a problem if I want to sell my bond to someone else. In order for my four per cent bond to be valuable to other people, I’ll need to sell it at a discount.

As mentioned earlier, my $1,000 bond is going to generate $40 of interest every year for five years. That means that I’ll receive a $200 yield over the life of my bond. A $1,000 bond with a six per cent coupon rate is going to earn $60 per year for five years, so the owner of that bond will receive a $300 yield over the life of the bond. That means I’ll need to sell my bond for only $900 dollars so that the buyer can earn a $300 yield from it, after you do the math. 

The price of bonds is also related to broader economic conditions. Some types of bonds—especially certain government-issued bonds—are often considered relatively safe assets. Therefore, if the economy looks like it’s going to slow down and people start to get worried that the value of their other investments might decrease, they might take their money out of those riskier assets and use it to buy bonds instead. This increases the demand for bonds and drives up their price. 

This article only scratches the surface of what goes on in the bond market, but bonds are an important part of the economy, and now, hopefully you know a little more about some of the basic concepts behind them.

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