Bond Basics

A bond yield is the return that a bond holder realizes. A bond’s coupon rate is the yearly interest rate of a bond. Since a bond’s price changes due to the economic forces of supply and demand, a bond’s coupon rate is not necessarily equal to a bond’s yield. A bond’s yield at any time is calculated as its coupon rate divided by its market price. Therefore, bond yield and bond price are inversely correlated: when one rises, the other falls.

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For example, imagine that you buy a bond with a face value of one hundred dollars and a coupon rate of five percent per year. This means that the bond holder enjoys a payout of five dollars every year from the bond issuer. Now, if a bank suddenly offers a new bond with a face value of one hundred dollars but a coupon rate of six percent annually, our original bond holder may want to sell his bond, since he would earn greater returns by purchasing the new bond with a higher yield. This is why increasing interest rates tends to lead to falling bond prices. This works both ways–if interest rates fall, then bonds whose coupon rate exceeds the new interest rate will rise in price as people’s demand for them also rises.

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In a market of bonds with diverse interest rates, the forces supply and demand will pressure bond prices to converge such that the effective yield–one that takes into account both the bond price and its yield–is equal across the bond market. While a bond’s price is subject to fluctuations, its interest rate is not.

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Bonds are bought and sold in secondary markets, after the issuer first creates and sells the bond. It is in secondary markets that a given bond’s price changes under the forces of supply and demand.

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The Treasury and the Federal Reserve

With the basics of bond economics in place, it is important to understand the distinct role that the United States Treasury and the Federal Reserve play in the bond market. 

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In general, the Treasury is responsible for managing the flow of money into and out of the federal government. The Federal Reserve, meanwhile, bears the official responsibility of managing the money supply such that the economy is kept stable (to be sure, the Federal Reserve causes economic instability in practice, but that is another story).

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It is the Treasury that issues government bonds and prints money, not the Federal Reserve. While the Treasury issues bonds, the Federal Reserve determines the interest rates on said bonds.

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The Federal Reserve’s power over bond interest rates means that the central bank has enormous control over the entire economy. For example, bonds impact mortgage interest rates. Because would-be investors in bonds would instead purchase mortgage bonds if the latter are perceived as a more productive investment asset, government bonds and mortgage bonds compete with each other. If the Federal Reserve sets interest rates too low, then there is pressure for sellers of mortgage bonds to do the same. Another way of saying this is that mortgage lenders correlate interest rates on mortgage-tied securities to Treasury bond rates.

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The Federal Reserve will raise interest rates on Treasury bonds as a means of curbing inflation. As explained earlier, bond prices fall as interest rates rise. Another way of putting it is that rising interest rates means that the cost of borrowing money has gone up. Acquiring new money becomes ‘more expensive’, and so entrepreneurs allocate their existing capital more discerningly. This all sounds fine, except that many businessmen had already invested capital in long-term projects when interest rates had been lower. Thus, rising interest rates puts such long-term projects at risk for going belly-up. 

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It is no exaggeration to say that the Federal Reserve is the most powerful institution in the United States. The ability to turn the knob on interest rates quite literally affects every aspect of the economy in which money is involved. 

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Bitcoin offers an alternative to the Leviathan Federal Reserve system: unlike the latter, Bitcoin is fully auditable, and the protocol does not change with the political winds of the day. One day, after Bitcoin establishes itself as the global reserve asset, we will look back with amazement that we have allowed our money to be controlled by a small cohort of men and women for over a century.