Bonds and interest rates

A bond is a loan

When you buy a bond, you're lending money. Say Sunny Slice wants $1 million to open shops, but doesn't want to sell more shares. So it sells bonds.

You lend Sunny Slice $1,000. It promises to pay you 5% interest, $50 a year, for 10 years. After 10 years, you get your $1,000 back.

• The $50 a year is the coupon. Long ago, paper bonds had little coupons you cut off and mailed in to get paid.
• The day you get your $1,000 back is the bond's maturity.

Owner vs lender

• A stock owner is a part owner. You share in the profit, but nothing is promised.
• A bond owner is a lender. You get set payments, but no extra if the company booms.

If a company fails, lenders get paid before owners. That's one reason bonds usually swing less than stocks.

Who borrows?

• The US government sells Treasuries. They're seen as some of the safest investments in the world.
• Companies sell corporate bonds. The riskier the company, the more it has to pay. Wobbly Waffles has to offer 9% to find anyone willing to lend. Bonds like that are called junk bonds, or high-yield bonds.
• Cities and states borrow to build schools, roads and bridges.

The seesaw

You just bought your Sunny Slice bond that pays 5%. Soon after, interest rates rise, and brand new bonds pay 7%.

Now you want to sell your bond. Who would pay $1,000 for a bond paying 5% when a new one pays 7%? Nobody. To sell it, you have to lower the price, to about $860, so the buyer's deal is as good as a new bond.

Rates up, bond prices down.

It works the other way too. If rates fall to 3%, your 5% bond is suddenly special, and its price rises to about $1,170.

If you hold the bond until maturity and the company pays, you still get your full $1,000 back. The price swings matter when you sell early.

Yield

A bond's yield is what it pays you each year as a percent of what you paid for it. The buyer who pays $860 still gets $50 a year, plus $1,000 at the end, so they earn about 7%. When the price goes down, the yield goes up. They always move opposite.

Why rates move every market

An interest rate is the price of borrowing money. When rates rise:

• Savings accounts and bonds pay more, so stocks have more competition for your money.
• Borrowing costs more for families (houses, cars) and companies (new shops), so business can slow down.
• Profit far in the future is worth less today, so fast-growing companies with a high P/E often fall the most.

When rates fall, it usually works the other way.

Bonds are safer than stocks, but not risk-free. In 2022, rates rose fast, and a big index of US bonds fell about 13%, one of its worst years on record.

Remember

• A bond is a loan: you get interest (the coupon) and your money back at maturity.
• Rates up, bond prices down. Rates down, bond prices up.
• Riskier borrowers have to pay higher interest.
• Interest rates touch almost everything: stocks, houses, loans and savings.