Reader Question: Bonds, yields, and Hershey bars
A Whiteboard watcher wrote in this week, saying she watched the Whiteboard video on the Fed buying bonds (Uncle Ben Goes Shopping), but still wasn't quite clear on the relationship between demand for bonds and bond yields.
This is a great question, because it goes to the heart of how bonds work and why they trade, and often trips people up. Here are three things you need to know about bonds, before you even start thinking about yields.
- A bond is a loan.
- A bond pays a fixed rate of interest over its life.
- Bonds can be bought and sold by anyone.
Imagine a school, where on Monday, June comes to the playground with a new jump rope and does some amazing tricks with it. Tony asks if he can borrow the rope until Friday. June agrees, on the condition that Tony give her a big Hershey's candy bar every day.
Mandy sees this, and decides she wants wants some of the same action. But none of the other boys will pay her more than a Tootsie Roll each day for her rope, even though it's new, too.
Mandy decides she will not settle for anything less than a Hershey bar. So she approaches June.
"Hey June, I heard you lent your jump rope to Tony. Aren't you worried that he'll break it?"
"Well, I'm getting a Hershey bar a day to lend it."
"But I know how much you love to jump rope. Won't you miss it?"
"Why don't you take my rope? It's exactly the same as yours. If Tony breaks yours, then I'll be the one without a rope, not you."
"What about the Hershey bars?"
"Well, I'd be taking the risk, so I'd take them."
"Well, OK. But only if you give me half a Hershey bar right now."
In case you didn't get it, when Tony borrowed the rope, he issued a "bond" to June - he agreed to return the jump rope in five days, and pay her a Hershey bar a day for the privilege of borrowing it. That makes June's yield a total of one jump rope and five Hershey bars.
Mandy bought the "bond" from June. Now she's the one lending the rope, and Tony will pay her the five Hershey bars. But it cost her a new jump rope and half a Hershey bar to buy the bond. So her yield is less than June's: one jump rope and just four and a half Hershey bars.
Now imagine if Mandy's sworn enemy Lindsay had wanted those Hershey bars. He might have offered June three quarters of a bar, or a whole one, to snatch the deal from under Mandy's nose. He might have sparked a bidding war, and the higher the sweetener paid to June, the smaller the yield.
The government is a bit like Tony. It's borrowing money from everyone from Mandy's Mom and Dad to the Chinese government.
And it borrows a lot. It issues its bonds all through the year, and it changes the interest rates that it pays constantly. A ten-year bond might carry an interest rate of 2.5 percent one week, and 2.4 percent the next. Investor demand for that 2.5 percent bond is going to be greater than for the other one, because they're getting paid more for buying it, even though it's no more risky. Investors will naturally pay more for that higher interest bond, and the premium they pay will cut into the yield: the total amount of money the investors would make if they held this bond until the government paid it down after ten years.
Do you like this explanation of how demand affects yield in the bond world? I'd love to know your thoughts!