Money & Markets

If You Don’t Understand Bonds, You Don’t Understand Money

Bonds quietly influence interest rates, stocks, inflation, and your financial future.

Photo by Austin Distel on Unsplash

Did you realize that the stock market, housing prices, and employment status are all influenced by a market valued at more than $130 trillion?

And no, it’s not crypto or the stock market. It’s the bond market.

In this article, I’ll explain what the bond market is, how it works, and how almost every financial decision you make traces back to the seesaw. But more on this later.

What Is The Bond Market?

The easiest way to understand what it is is to imagine you’re buying a house. You don’t have enough money to buy it in cash, so you go to the bank.

You ask for some money. Then you walk out with this little piece of paper called an IOU. You promise that you will pay the bank back the money with a little bit of interest on top.

Now, borrowing money is pretty normal for anyone or anything that spends money.

Now the government spends money too, on things like school, health care, and fixing potholes on the road, they say. The government gets most of its money from taxation. So in 2024, the federal government collected something like 4.9 trillion dollars in tax revenues. Roughly half of that was from individual income taxes.

Now, here’s the problem. In 2024, the government spent about 6.8 trillion dollars in spending, meaning there’s about a 1.8 trillion dollar gap between how much money it brought in and how much it ended up spending.

Even if you added up the entire country’s GDPs of Sweden and Thailand, that number would still be smaller than that 1.8 trillion-dollar gap.

And somebody has to fill in the gap.

Now the government doesn’t just stroll into a Chase Bank down the road and stuff it. Instead, they borrow it in the form of bonds. So the government comes to you, to investors, to private companies, to countries, saying, “Look, if you let me borrow a hundred dollars today, I promise to pay all of you back with a little bit extra on top. Let’s say 5% interest over 10 years.

You agree, and then the US government walks out with this little IOU, promising to pay you back.

Now, this little slip of paper is what’s eventually going to impact the housing market, the stock market, and the job market.

But first, there are three key terms you need to know. Once you understand them, everything is going to click.

First, we have the principal, which is the hundred dollars the government is borrowing from you, or you are lending to the government.

Then, we have the coupon, which is the interest payment or the interest rate that you actually receive from lending the government money. In this case, a 5% interest on a hundred dollars is five dollars that you receive every year.

Then, you have maturity, which is the timeline that the government has to pay you back your principal, in this case, 10 years.

So, principal, coupon, and maturity, and now you understand the basics better than most people.

Now, every time the government needs to borrow money, which happens every week or every month, they sell these new bonds to you, companies, and countries. All this happens in a place called the primary market.

But knowing what a bond is isn’t the interesting part. It’s what happens after someone buys one.

Now, the reason everyone is okay lending trillions to the US government every year is that the US government is considered a really safe borrower, meaning you’re almost certainly going to get your money back.

Okay, so that’s how new bonds are born.

But the thing that most people miss is that the primary market isn’t really what moves the economy. It’s really what happens next on something called the secondary market.

So, just like how you buy and sell your clothes, you can also buy and sell your old and existing bonds in this place called the secondary market.

Think of it like eBay for old bonds.

In the secondary market, you can buy and sell existing bonds for a certain price, which is determined by this yield seesaw.

So, yield is just a fancy way of saying what the percentage return is that you’re going to get from this bond?

And yield is different from the coupon or interest payments that we brought up earlier because your yield percentage changes depending on the price, but your interest payments stay the same.

Now, this is the part that trips people up a lot, so I’m going to use real numbers.

Let’s say you just bought a hundred-dollar principal bond that offers a 3% interest rate, meaning you get three dollars every year in interest payments.

But a few months later, the government issues a new bond. This time, it’s offering 4% interest on the same hundred-dollar principal.

Additionally, the bond you previously bought is now less appealing to buyers on the secondary market since a new bond that pays four dollars in interest annually is more appealing than paying $100 for a three-dollar annual interest payment.

Now, if you really need to sell your old bond on the secondary market, there is one thing you can do to make it more attractive, and that’s by changing the price you’re willing to sell it for.

So, to make it more attractive, you decide to lower the price you’re willing to sell your old bond for to 70 dollars.

The federal government continues to offer a 3% interest rate on your old bond, which still only pays $3 annually. It is now more appealing than the new bonds being issued in the primary market, which carry a 4% yield, if you take that $3 and split it by the $70 price that someone is ready to pay.

If the federal government issues new bonds with a lower rate, the converse occurs. Your prior bond with a 3% interest rate becomes more appealing, and you may sell it for a greater price on the secondary market because they are now issuing new bonds at 2% rather than 4%. Similarly, that one’s yield % would decrease.

That’s the yield seesaw.

When prices go up, yields go down, and when prices go down, yields go up.

When you go to a bank and ask to borrow money to buy a house, most people think that the bank decides the mortgage rate to give you, but they don’t. The bond market does.

Banks will look at the yield that new bonds are offering, use that number as a benchmark, and then add a couple of percentages on top of it, and then tell you that that’s their mortgage interest rate.

Lending you money to purchase that house is riskier than lending the government money, which is why they add additional percentages. Therefore, the additional percentages are merely their compensation for assuming that extra risk.

For example, back in January 2021, the 10-year bond yield was around 1%, and banks were offering mortgage rates at around 2.65%, which is the lowest interest rate for a mortgage that we have ever recorded.

Meaning, a ton of people tried to borrow money to buy a house because it was so cheap to borrow. This led to so much demand for houses that sellers increased their sale prices, resulting in home prices jumping up 19% in one year.

To put that into perspective, the average home price increase over the last 50 years is about 4% per year.

Fast forward to October 2023, and the 10-year bond yield hit 5%, and the mortgage interest rates jumped to over 8%.

Now, potential home buyers are like, “Uh, it’s really expensive to borrow money, so I’m just going to sit this one out.”

Typically, sellers would reduce the price of their homes to make them more appealing when the demand for purchases declines. However, a lot of homeowners have already locked in at extremely low rates since 2021, which has made the last few years extremely strange.

The majority of them were unwilling to sell their current home in order to purchase a larger one because doing so would require them to exchange their 2% mortgage rate for, say, an 8% one. This is a major reason why, despite fewer purchasers, housing prices haven’t decreased significantly as of yet.

So, when mortgage rates go up, it’s not the bank making the decision. It’s the bond market making it for them.

When rates go up, everything from home prices to mortgage payments goes up, which basically decides who can afford a house in today’s economy.

The Stock Market

But it doesn’t just stop there. The bond market also controls whether or not you make money or lose money in the stock market.

The easiest way to understand this is to imagine that you are an investor, right? And your goal is to maximize your money.

Let’s say you have a hundred thousand dollars to invest, and you have two choices to pick from.

The first choice is to invest in stocks, which is generally considered risky. It can go up, it can go down, but the potential upside is there.

The second choice is to buy bonds from the US government, which has basically no risk with it.

Now, here’s the key question, right?

How much extra return do you need from stocks to justify taking on the extra risk over the guaranteed return from bonds?

This is called the equity risk premium, or ERP.

For example, if a 10-year bond pays a 5% return guaranteed by the US government, and investors expect a 7% return from the stock market, then the ERP is 2%.

Now, here’s the part that most people have trouble connecting.

The ERP percentage basically explains why the stock market did what it did over the last 15 years.

For instance, a 7% projected stock market return sounds quite appealing since it is a 6% equity risk premium if bonds yield nearly nothing, as they did in 2021 when the 10-year was under 1%, which hardly outpaces inflation.

So, investors will move a bunch of their money into the stock market, which makes it go up, which is what happened from 2009 to 2021.

The Fed kept rates really low, and bonds paid almost nothing. So, the S&P 500 went from about 600 points in 2009 all the way to 4,700 points by the end of 2021.

But if a bond pays a guaranteed 5% return, as it did in 2023, and you still think the stock market is going to return 7%, then that’s only a 2% ERP.

And this 2% difference might not be worth the extra risk that the stock market has, which is what basically happened around 2022.

New bonds were offering around 4% interest, and people moved their money away from the stock market into the bond market, and the S&P 500 dropped nearly 20% in a single year.

The relationship between bonds and stocks isn’t just about where investors put their money. It’s about what return they’re willing to accept for taking on additional risk.

When safe government bonds offer attractive yields, the level for what stocks need to deliver becomes higher.

All right, so now this next part is what I think you’ll care about the most because it’s how the bond market basically decides whether your company can afford to keep paying you or not.

The Job Market

And if you made it to this point, claps to you. I know it’s not the most interesting topic.

One thing many people don’t realize is that many companies don’t only pay their employees from their revenue. Many growing companies borrow money to fund their operations by selling corporate bonds or taking on loans.

Corporate bonds are pretty similar in concept to government bonds, except that it’s companies offering them.

When a company issues a corporate bond, investors will look at the company’s credit rating and see how likely it is to pay it back because companies can always go bankrupt.

The riskier the company is, the higher the interest rate that investors would demand, because why would I, as an investor, buy a risky corporate bond for the same interest rate that I’m going to get if I buy a US government bond?

Now, companies issuing higher interest rates for their corporate bonds is all fine and dandy until one specific moment. And this is where people tend to lose their jobs.

Let’s say you own a company that sells pineapple pizzas. And back in 2021, when US government bonds were around 1%, you decided to borrow money by issuing a bunch of corporate bonds at a 3% interest rate.

You used all this money to expand. You built factories, you hired a bunch of workers, and you did a bunch of R&D for better pineapple pizza.

But now, a few years later, right in 2023, it starts rolling around. This is when all the trouble starts.

Now, it’s pretty common for companies to refinance their debt, meaning they again issue new bonds to pay off their old bonds instead of using cash.

However, the US government bond rates have now increased to, say, 5% in 2023, which means that in order to make new corporate bonds appealing, you must now issue them at a higher rate.

So, instead of the 3% you originally offered, now you’ve got to offer 7%.

That’s more than double the interest expenses, right?

Imagine if your rent just suddenly started doubling. Now you’re scrambling, trying to find a way to cover that higher interest cost.

So, you start to aggressively cut your budget. You lay off workers, you close down stores, and you empty some factories just so you can pay off your debt.

And that is exactly why we saw so many layoffs in 2023 and 2024.

It wasn’t just the economy. It was the bond market.

And when there is more fear and uncertainty in the market, investors will demand a higher interest rate from corporate bonds since the investment feels riskier.

And the gap between safe government bonds and risky corporate bonds is called the high-yield spread.

When the spread widens, it’s usually a signal that there’s some trouble in the markets.

This is why the bond market is so important to understand, because it directly shapes the economy, which shapes your financial life.

Every time the bond market moves, the prices for nearly everything change because, as interest rates go up, the economy slows down.

So, if you want to build wealth, you need to know exactly how to make the bond market work for you instead of against you.

And it all starts with knowing where to actually put your money.

Because here’s the thing, right?

Now that you understand how the bond market moves interest rates, the next question is, what do you actually invest in to make this all work for you?

Thanks For Reading:)

📩 Join Investor’s Handbook Digest — get the best investing, markets, and wealth-building insights each week.