Looking into Bonds

In full disclosure, this article will not be about the current bond-yield curve nor its implications for economic prognostications or forecasting. Still, like many others, I was drawn into understanding what bonds are because of my curiosity to know what all these famous economists and bankers were saying when they referred to when mentioning “inverted” bond yields.

My journey to understand what this market action was, began with learning about bonds. Generally, a bond is a loan or loan certificate packaged by banks or other financial institutions and sold in the markets at $1,000. The bonds are sold at that price, and their return is the “return rate” or “bond rate,” sometimes known as a “bond yield.” The bonds’ “term” can range from 90 days, sometimes known as a short-term bill, or up to 30 years, where longer than a year can also be called “notes.” The markets set the interest or “yield” rates, which will be willing to “lend” money to fund the bond at a specific interest rate for a predetermined time. Usually, the longer the time, the higher the interest rate is. Again, this oversimplifies the bond market and how the bond rates are set.

Things get a bit complicated. On my first purchase of a 3-month bond, I paid not $1,000 but $99.118 dollars per bond certificate. So, what happened? Historically, the market sells the bonds at ’10 bonds’ per $100. The $99.118 I paid per bond was “discounted” per a coupon rate. I paid $991.18, but at $99.118, multiplied by the ten bonds purchased. Why? Historically, bonds were sold at $100 intervals to accommodate the smaller-sized loans needed. Though today’s companies request higher amounts, that small detail has not changed.

From here, things get more complicated. What’s a coupon rate, and what is the difference between that and the yield rate? The difference is subtle, but they are similar. The difference is this, when you buy a bond with a yield, at the term, you get paid out the $1,000 that you paid at the end, and semi-annually you get paid the interest. A coupon rate is a discount for lending the bond, and at the end of the term, you get paid $1,000. The “yield” or interest in the bond is embedded in the price paid upfront, thus the initial cost of $991.84.

Understanding this, we can include one more thing. If bonds are set at specific “prices,” yield, or interest paid, can we game the system to increase gains or upfront them? That is where my small experiment to understand bond spreads began. It is not thoroughly tested, but I received decent profits; see the attached PDF:?XLSX Bond Spread. If the yields are inverted, the market expects rates to fall in the future, can I purchase a bond today, at a “higher” price, and sell it in 6 months to a year into a market with lower interests rates, and what spread would I be able to gain? I attempted this. I purchased 10,000 6-month bills at a $99.118 coupon rate on November 02, 2022, sold all of them, and got $99.34 for the sale of those same bonds on November 16, 2022. I gained .1% or an annualized 4.19 percent in less than two weeks. In this case, the gains were insignificant, but that is the base case for the mechanism used to create this bond template. The template does not reflect market prices; the templates are not investment advice but an experiment on my part to understand bonds better. Please consider all risks and possible losses before attempting these risky allocations of investments.?

In this case, the risk is that a premature sale of the bonds in a market with higher rates would have given me an inevitable percentage loss; those are not included in this example, nor was it meant to extrapolate these risk losses. The other risk is that I keep them all to term and cannot use them for other investments or personal consumption. The risk may seem minor, but when considering the second option, ensure that you have conducted proper risk management and opportunity costs when allocating any sums of money into bonds or any investment.

Please take apart this small essay and the bonds spreadsheet to find issues. I am still waiting to learn all that bonds are and how their rates are set. Feel free to comment on this post or send over ideas, questions, and critics. I am always willing to discuss the financial instruments used to lubricate our everyday business operations.?