Bonds and rates: the price of money

Bonds are the quieter half of investing, but they set the price of money for everything else: mortgages, car loans, savings accounts and even stock valuations. Understand one simple seesaw and the rest falls into place.

How a bond works

A bond is a loan. You lend money to a government or company, and they promise to pay you interest on a schedule and return your money on a set date, called maturity. Buy a $1,000 ten-year bond with a 4% coupon and you collect $40 a year for ten years, then get your $1,000 back, assuming the borrower does not default.

The safest borrower in U.S. dollars is the U.S. government. A Treasury is debt issued by the U.S. Treasury Department, with maturities from a few weeks to 30 years. Companies pay more than the government to borrow, and that extra yield is the credit spread, which tends to widen when investors worry about defaults.

The seesaw: prices and yields

A bond's yield is the return you earn based on the price you pay. The key rule: when interest rates rise, existing bond prices fall; when rates fall, prices rise.

Back to your 4% bond. Suppose rates jump and new ten-year bonds pay 5%, or $50 a year. Nobody will pay full price for your $40-a-year bond when $50 is on offer, so its market price drops until its yield to a new buyer is competitive. If rates fall to 3% instead, your bond becomes the attractive one and its price rises.

Hold the bond to maturity and you still get your $1,000 back. Price swings matter if you sell early or own a bond fund, and their size depends on duration. As a rule of thumb, a bond fund with a duration of 6 loses about 6% if rates rise one percentage point. That is why 2022, when rates rose sharply, was one of the worst years on record for bond investors.

The yield curve

Plot Treasury yields from the shortest maturity to the longest and you get the yield curve. Normally it slopes upward, because lenders want more to tie money up for ten years than for three months. When short-term yields climb above long-term ones, you have an inverted yield curve. The most-watched version compares the 2-year and 10-year Treasury yields.

An inversion suggests the market expects rates to fall later, often because it expects the economy to weaken. Inversions have preceded many past U.S. recessions, but the lag has ranged from months to years, and the signal is not guaranteed. The curve inverted in 2022 and stayed that way for an unusually long stretch. Track the live 10-year minus 2-year spread on the Pulse dashboard.

The Fed's lever

The Federal Reserve's main tool is the fed funds rate, what banks charge each other for overnight loans. Its policy committee, the FOMC, sets a target range at eight scheduled meetings a year.

• Raising rates makes borrowing more expensive and cools spending, aiming to bring inflation down. Savings yields rise; loans and credit cards cost more.
• Cutting rates makes borrowing cheaper, aiming to support jobs and growth when the economy weakens.

The Fed steers short-term rates directly. Long-term rates, such as the 10-year Treasury yield that heavily influences mortgage rates, are set by the market and reflect expectations for growth, inflation and future Fed moves. Rate changes ripple into stocks, too: higher rates make future profits worth less today and give investors safer alternatives, which is why markets hang on every Fed announcement.

Where bonds fit

High-quality bonds pay steady income and have often, though not always, held up better than stocks in downturns. In 2022 stocks and bonds fell together, a reminder that no asset is a perfect shield. Blending them is the subject of Diversification and allocation.