When you hear the term volatility, your mind might think of a child’s temper tantrum, Colorado’s weather or even the stock market. Most of us don’t relate volatility to the bond market. In Q1 of 2021, the bond market experienced a bout of volatility, largely due to the jump in treasury yields. In this article we will discuss how a bond works, and what has been going on in the current environment.
What is a Bond?
A bond can easily be compared to a loan. There is a lender and a borrower—the borrower pays an interest rate and the lender receives the interest rate as compensation for lending the money. Bonds are issued by companies and governments usually to finance projects or capital improvements. Good examples are savings bonds, U.S. treasury notes or a company like Tesla issuing a bond to fund building a new headquarters. Usually, companies or governments issue a certain amount of money needed to fund a project, create a term or a maturity and decide on a fair interest rate. The maturity date is when the principal is due back to the lender or investor. The interest rate is what the government or company will pay the investor or lender. Interest rates are determined based on a variety of factors such as the ability to pay back debt and current interest rates on U.S. treasuries. Usually, the interest is paid on a semi-annual basis.
How do Bonds Work?
Now that you have a basic understanding of bonds, commonly referred to as fixed income or debt, how does the pricing work? Well, because interest rates are always fluctuating, quality of companies are going up and down based on their balance sheet and income, bond pricing varies. Bonds, typically, move in much smaller increments than stocks and bond prices are inversely correlated with interest rates, meaning if interest rates go up, bond prices go down and vice versa. If a bond was issued a year ago at 3% interest rate, and today you can get a new bond at 4% interest rate, you wouldn’t pay full price for the old bond because you would want to get compensated for the current rates, therefore the price on the old bond has to come down.
Q1 Bond Market Update
On January 4, 2021, the first trading day of the year, the 10-year treasury yield was around 0.93%. On March 31, 2021 the 10-year yield was around 1.74%. The 80 basis point increase, which almost doubled is a huge move in yields which caused bond prices to decrease. A majority of bonds showed a negative return for the first quarter because of the volatility of yields or interest rates. Since the first quarter, yields have stabilized and bonds have started moving in a positive direction again. We have been closely monitoring the fixed income markets, talking with multiple bond managers about strategies to reduce volatility and risk and making changes to some of our portfolios. Make sure to check out SHJ’s economic videos by economist Larry Howes to find out more about what’s going on in the bond market and the overall economy!