Bonds.

Normally they don’t get much of a look-in – newspapers and message boards spend far more time talking about shares, currencies and even commodities. Call me biased – and I am – but I suspect that’s because bonds are boring. If bonds were at a party they’d be the guy with the acne and the side parting that nobody wants to talk to. But right now it seems they’re all anyone wants to talk about. That’s because bond yields, which normally don’t fluctuate too much, have been hitting 5 year and 9 year highs.

What I, and everyone else, wants to know is what these highs mean for the stock markets. So I’m setting myself the, errr, “challenging” task of to write a short, simple explanation of the relationship between bond prices and share prices. The reason this is challenging is that, while discussing bonds is going to throw up a few twists and turns, explaining the relationship between bonds and the stock markets is going to be like unravelling spaghetti. There’s a good few theories about their relationship, but some contradict others and not a one can explain the connection in full.

To make life a touch simpler all I’m going to do today is explain what bonds are and maybe waffle on a bit about the bond markets. Hopefully early next week I’ll get a chance to cover the rest of it.

Now let’s get one thing straight before we start: a bond in the financial markets has very little to do with the Guaranteed Savings Bonds, Equity Bonds, Tracker Bonds, Capital Protection Bonds etc. that your high street bank might be advertising in it’s window. These types of instruments are usually a type of fund onto which some accursed marketing person had slapped the word bond so as to give it an air of respectability.

A bond or ‘fixed income’ instrument is basically a loan. In simple terms the borrower borrows a sum of money from a lender for a certain period. For that period the borrower pays interest at a fixed rate and at specified intervals of time. Once the period is up the borrower repays the money. It’s pretty much like taking out an interest-only mortgage: you borrow a sum of money, pay the interest and, at the end of the load period, you repay the original sum of money too.

If you’re the type that likes jargon, here we go:

• the guy doing the borrowing is called the issuer
• the guy doing the lending is called the bond-holder
• the amount of money borrowed is called the ‘nominal value’ or ‘par value’
• the amount of time until the loan must be repaid is called the maturity
• the interest payments are called ‘coupons

Issuers can be lots of different organisations but the most common are governments and companies:

• Governments sell bonds to help the financial markets or, if their economic situation isn’t so rosy, to fund their spending deficits. Effectively they can treat the bond market like one great big bank overdraft. The German Bundesbank sells Bunds and BOBLs, the Bank Of England sells Gilts and the Feberal Reserve sells US Treasury Bonds (T-bonds).
• Companies sell bonds for the same reason they sell shares: in order to raise money for expansion or whatever else they happen to need cash for.

The bond holders are often large financial institutions e.g. asset managers, pension and insurance companies. Unlike shares, very few private individuals get involved in the bond markets.

One key thing about bonds is that they are (mostly) tradable. In other words if a bond holder gets fed up with holding a bond he or she can sell it. And, like anything else that can be bought and sold in the financial markets, the price of the bond can go up and down.

I hope you’ve stayed with me so far ‘cos here comes our first bit of spaghetti: when someone says “bonds are up” what they generally mean is that bond ‘yields’ are up. As bond yields and bond prices are inversely related, when the yields are up the prices go down. So when they say “bonds are up” they probably mean that bond prices have fallen. Now if you didn’t understand a word of that, don’t panic. I’ll explain what a yield is with a simple example.

Lets start by inventing a company called DeDo.com. DeDo decided they need to expand so, via a broker, they sold a bond to Pensions-R-Us. The bond had a par value of USD 1 million, maturity of 10 years and paid a fixed rate of interest of 7%.

That means Pensions-R-Us has paid 1 million for the bond and will receive a coupon of USD 70,000 every year for the next 10 years. At the end of the 10 years they’ll also get their USD 1 million back.

In bond world the amount of money that you get from holding the bond is expressed as a percentage of what you paid for it and is called the ‘yield to maturity’ or, more often, the ‘yield’. The method of calculating the yield is complicated as it needs to take into account the coupon, the par value and the time to maturity. There’s a less than simple explanation on wikipedia; if anyone can find a simpler one do put it in a comment below. However in this example the yield Pensions-R-Us are receiving is the same as the interest rate: 7%.

After two years Pensions-R-Us get fed up of holding the bond and decide to sell. As we said bond prices can go up or down so the price they got could have been more or less than the USD 1 million they originally paid.

In our example we’ll say bond prices fell, so the bond was sold to ForSureForSureInsurance for just USD 915,000. ForSureForSure are still receiving the USD 70,000 p.a. coupon and they’ll still get the USD 1 million back at maturity. However they’ve paid less than Pensions-R-Us so the money the are making on the bond (as measured by the yield) is around 8.5%. That’s somewhat better than the 7% yield Pensions-R-Us were receiving.

The important point is that the bond price went down (from USD1 million to USD 915,000) and the yield went up (from 7% to 8.5%). In other words bonds and stocks have an inverse relationship:when one goes up the other goes down. Just like stalagmites and stalagtites.

In fact this concept shouldn’t seem too weird to anyone who is familiar with stocks and shares. After all when a share price goes down the share’s dividend yield goes up.

Last week US 10 year bonds yields hit a 5 year high, which of course no-one was too happy with because that meant the price had hit a 5 year low. Yesterday (21st June ‘07) UK government bond yields hit a nine-year high and today they came pretty close again.

Of course the main thing we haven’t discussed here is what makes the price of a bond go up and down. And much though I hate to leave you on a cliff-hanger (how will you survive the suspense) I think this blog is long enough. So we’ll cover factors affecting bond prices, as well as the relationship between bonds and stocks, in the next post on bonds.

Until then: may the markets be with you.

P.S. the calculator I used to work out the yields for this example is on the moneychimp website