Bund, Bobl and Buxl … the bond market explained: an idiot’s guide

Despite being the largest most liquid markets on the planet (bigger than global equities and Forex), the bond markets remain opaque to many investors.

US bonds (valued at over $51 trillion) take up nearly 40% of that global market, with China some way behind at $21 trillion.

But changes are afoot in the bond markets … and they matter to all of us …

What is the bond market?

Bunds in Germany, OATs in France, Gilts in the UK and Treasuries in the US … all of these are loans made to the respective governments.

Bonds are how governments borrow money – you give them your £1,000, and they’ll pay an annual return (of, say 4%). You pocket your £40 interest payment each year, and you get your original investment back at the end of the 5 years … 10 years … 30 years … whatever the expiry of the bonds you invested in.

It’s a nice, safe way to invest, but 30 years, or even 5 years, may feel like a more committed relationship than most people want to make. But, should you get itchy feet, you can sell your government bond on a secondary market.

If, in the meantime, interest rates have gone down, and the bonds are now offering a return of just 3%, your old 4% bond will have gained value, and you’ll be able to sell it for more than the £1,000 you paid for it.

This little explainer video shows what bonds are, and how their prices are affected by interest rates …

Terms you’ll need to know to talk about the bond market

If you want to sound like you know what you’re talking about in bonds, these are some of the terms that’ll come up …

Issuer: the government or corporation that issues the bond.

Bondholder: the investor who buys the bond

Par Value: the principal value of the bond, on which interest is paid.

Price: the value of the bond at any time (usually shown as a percentage of the par value).

Coupon: the rate of interest paid out by the issuer to the bondholder.

Maturity: the date at which the bond will be paid back.

Premium: when a bond trades at a value higher than its par value.

Discount: when a bond trades at a value lower than its par value.

Yield: the rate of return on the bond, calculated as: coupon / the bond price

Yield to Maturity (YTM): the total percentage a bond will return if held to maturity.

Treasuries: bonds issued by the US government (T-bonds).

Gilts: bonds issued on behalf of HM Treasury in the UK.

JGBs: bonds issued by the government of Japan.

OATs: bonds issued by the French Treasury (these represent the largest share of the European bond market).

Bund, Bobl, Schatz, Buxl: German government bonds, of different lengths, from 35 years to 42 months.

So, what’s happened to the US bond markets?

In the US, bond yields have shot up, and the price of old bonds has slumped sharply.

Why?

A popular narrative is that there’s more and more debt, and finding buyers for it is getting harder, so yields have to go up. Whilst there’s some truth in this, in fact, there just hasn’t been the massive debt issuance that many commentators are telling us there is. In fact, comparing Federal debt compared to GDP, it’s been coming down off its pandemic spike.

The main drivers are, of course, inflation and high interest rates, meaning that the yields on bonds need to increase to lure in buyers. And it follows that these higher yields are slashing the value of bonds already being held by investors.

Add to that, the fact that China sold $16.4 billion of US bonds in August, and there’s nervousness about finding buyers for US debt going forward.

And due to the efficiency of the markets, what happens in the US, has a knock-on effect on bonds around the globe, with similar patterns repeating in the UK, the Eurozone, Japan …

If you think this doesn’t affect you, because perhaps you don’t hold any bonds … think again.

The bond market is the engine behind global finance. Government debt is sizeable, and this affects anyone who pays tax, has a pension, is investing for the future, or just wants to use public services.

What does this mean for investors?

Bondholders will have taken a hit on the value of their bonds, but the rising yields make bonds an attractive option to new buyers.

Ten-year treasuries at 5% are causing quite a stir; especially when you consider that just 3 years ago, ten-year bonds were offering 0.5%.

The knock-on effects of rising bond yields is bearish for the stock market. The two tend to have an inverse correlation – as bond yields rise, indices fall. High borrowing costs hamper investment by companies, and many people will be lured away from the risky stock market by that chunky 5% return from safer bonds.

High bond yields can also hamper the rally that gold is enjoying – gold isn’t interest-rate-bearing, so in a high-interest-rate environment it becomes less appealing.

All in all, it’s a perspective shift for investors, many of whom have never experienced an era of high interest rates. The dynamics of the markets are ever-changing – and smart investors adapt to survive.

 

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