Behind the Scenes: Bonds Unwrapped | Zurich Money Mindset Podcast

Episode 6 of Zurich Money Mindset Podcast “Behind the Scenes: Bonds Unwrapped,” Ross Hutchison, Head of Eurozone Market Strategy & Economics, explains how bonds work and gives insights from historic coupons to today’s bond markets.

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Rumor has it that fortunes are not always made in glittering stock exchanges, but quietly, on pieces of paper, like the one our host is dramatically unrolling before you now. This is a Spanish government bond from over 100 years ago. You would have to physically cut a coupon out and take it in for payment. Obviously, you don't have to do that for modern bonds, but there are remarkable similarities as to how these instruments actually work. We will be talking about this on the current episode of the Zurich Money Mindset Podcast, which you can check out, as always, on the Zurich Money Mindset Hub. Now, when you turn on the evening news, or as I said before, when you're walking down the street and you pass a bank and you see all these flashing numbers up down, often they represent the stock market, the equity market. We covered that in the last episode. But we've also spoken a bit in a series about the bond market generally. And it's actually larger than the stock market. It's of importance for governments, for corporates, for borrowing, and of course, for investors as well. But sometimes people get a little bit baffled by some of these concepts, prices, yields, up, down. It's actually not as complicated as it often appears. In this episode, we're gonna be talking about the bond market, and please, as always, do not forget to do the trifecta. Like, comment, subscribe. I'm very happy that I remember them all. I often worry that I won't. Please do all three of those. Right, let's start with the fundamentals. What exactly is a bond? Now again, I have spoken about this in past episodes, but I want to reiterate it here, read this still down, that concept. It is basically a debt instrument. If you issue a bond, you are a borrower. If you buy a bond you are a lender. So when governments, for example, want to undertake large fiscal packages, or let's just say like an infrastructure, project, a large highway construction, they will have to issue bonds in order to fund that. These are large billion dollar style of investments and bonds are issued. Like with corporates as well, they also will issue bonds for corporate expansion, for ongoing operations. Now, if you buy a bond, you become a lender. You're parting with your hard-earned money and lending it to a government or to a corporate. Now, in exchange for that money, they will promise to pay you back that money at a fixed point in the future, let's say five, 10, 20, or 30 years from now. But in order to entice you to part with your money for that period of time, they will pay a regular[interest] payment over that time. That's called the coupon on the bond. Now there are all different types of bonds, amortizing bonds, bonds with inflation linked component. The most important bond out there is what we would call a fixed coupon and fixed maturity bond. That's a plain vanilla bond. These bonds will have a maturity date, maybe 10 years in the future, maybe 30, maybe even 100 years in the future. And they will pay a regular coupon. That's the number on the bond that you would have seen at the beginning of the video. For example, in that Spanish bond, it was a 5% coupon. An example could be that could be paid every single year to the investor. Now, not all loans or investments here are created equal. There's different risks associated with buying different kinds of bonds. As I said before, government bonds tend to be perceived as slightly lower risk than corporate bonds and that means that they often require a lower coupon or a lower yield than risks on extremely risky, let's say adventurous new frontier brand new companies who are trying to raise money in the capital market. Now I'm going to talk about what we would call the seesaw effect of prices and yields when one goes up, the other goes down, and vice versa. Once a bond is issued to the public, it doesn't just sit in a vault, it's actually actively traded in the market, just like stocks are. That can create a situation, as I'm sure you'll often see when you hear things like interest rates have gone up and bond prices have gone down. But why exactly does this happen? Let's just think of a really simple example. Imagine you had bought a bond and it was a good investment, it was continuing to pay that coupon. The coupon and the yield on that was 3%. Now, if interest rates in the economy overall were going up because the central bank of that economy was raising interest rates, let's say they brought them up to 5%. Then, who's gonna want to have a bond that has a 3% coupon or interest rate on it? Because the new ones offer 5%. Well, the mechanism that changes that is the price of the bond itself has to change to mean that new investors who buy it will get something similar to that 5% prevailing interest rate overall. That's why we say when prices go down, the yield on that bond, which is a 3% coupon, will actually be higher because you have paid less. So this operates like a seesaw. When prices go, down yields go up, and when prices goes up, yields go down. I use an example there of a bond that was 3% when the prevailing rate was now 5%. But what about the opposite case? We had a 3% bond and central banks were cutting interest rates down to 1% or even, let's say, 0%. Well, then you have a bond that has a 3% coupon. People in the market will be willing to pay more for that bond. So it works in both directions and the price will have to increase in order to mean that the yield on that bond will actually be lower. So again, yields up, prices down, as just described. There's one other thing I wanted to talk about with the bond markets overall. As I said, lots of people talk about the stock market, very exciting, much larger moves in general, although not always. But one thing that's really important for investors in the bond market is there is lots of information contained in bond prices. So for example, When investors look at bond prices, I talked about interest rates before, well, investors are able to work out from the price of bonds over different maturities what the interest rates are likely to be in the future, or at least what the market thinks interest rates will be in future. It will price in a path over time. And there's lots of information in there for market analysts, for economists, and even let's just say for information about what borrowing rates might be in the future. The other thing that bond prices contain is information about expected inflation in the future as well. There are bonds that have inflation linked coupons. They are based on what inflation is going to be in future. And investors use these compared with fixed coupon bond prices to work out what inflation is going to be in the future. So there's tons of information out there for professional investors and general investors alike. So while stocks might give you those thrilling headlines, the bond market is maybe slightly behind the scenes but is larger in scale than the stock market and has lots of implications for the macro economy and investors alike We talked about the seesaw effect of how when prices go up, yields go down. When yields go up prices go down and vice versa. We also spoke about how. The bond markets themselves contain lots of information about the expected path of future interest rates and what investors think inflation is going to be in the economy overall. That's it for today's episode of the Zurich Money Mindset Podcast. As always, you can find us on the Zurich Money Mindset Hub and thank you very much for tuning in.