The Bond Market is the biggest financial market globally. It is, in fact, about 3 times the size of the global equity market. According to the Securities Industry and Financial Markets Association (SIFMA), the size of the bond market is estimated to be $119 trillion worldwide, and 46 trillion in 2021. Canada participates with around $210 billion in 2021.
How come such a big financial market is not commonly discussed or understood, yet it is widely used?
To answer this question, first we need to understand how the bond market works. The bond market is a debt/credit market. There are debt issuers who create the bonds (Primary market), and there are buyers and traders who consume the bonds (Secondary market).
The debt issuers are mainly governments, but there are corporate issuers who crossover to the equity market as well. For simplicity reasons, we are going to just focus on government bonds for this article, since this level of bonds are commonly referred to as “conservative investment” or “fixed income”.
Now, this may ring a bell for many investors, as you may/should have some conservative investment in your portfolio. As risk is a relative standard, we are assuming that fixed income exists in most Canadian investable assets. At least, we can safely assume that it is widely used for the retiring and retired individuals, and their pension plans. CPP funds and corporate pension plans are big consumers of the debt market.
A bond is like a GIC (Guaranteed Interest Certificate) from a bank, except it is from a government. It is a loan to the government for a fixed time frame, in exchange for a fixed interest rate. Unlike GIC, bonds are liquid. Since it is liquid, it is very popular among retired individuals and pension plans, as it can be liquidated to fund a monthly income payment. There are pros and cons to this key feature, which will be explained later.
Bonds are rated by ratings agencies for their creditworthiness, and assigned a rating, for example, AAA, AA, BBB. In general, the higher the rating is, the lower the interest rate it will pay out. That is a big reason why government bonds are so popular, at least that is the case in North America. It is simply because the ratings are very good. It is very unlikely that the Canadian government or the US government will go bankrupt, which is the case for them not to pay back the bond payments (coupon payments).
How/Why can my bonds fluctuate in price?
A bond sounds like a GIC which is issued by the government, and it can be cashed out whenever an individual wants/needs. As long as the rating is good, it should be a safe and worry-free investment, right? Well, in general, it is the case, except when the interest rate is moving up or down. In particular, when the interest rate is going up.
A 10 year – federal government bond – which pays 3% (interest rate) per year. We will refer to this bond as the example and reference point. If you purchase such a bond, and collect the interest every year, and hold it until maturity (10 years). It is just like a GIC which is issued by the federal government. No volatility is involved.
However, if you purchased such a bond, and sold it before the maturity date for funding a retirement income or any other reasons, the selling price is determined by the current interest rate. In general, when interest rate rises, existing bond prices (evaluation) falls, as new bonds are issued at a higher interest rate.
If we can go back to the example. You are holding a 10 year 3% bond for a number of years. As interest rates rise, you can buy a 10 year bond at 4% now. If you want to sell your 10 year 3% bond at this time, the price needs to be lower, or the buyer can just buy the new bonds. The reverse is true. As interest rates fall, you can sell the 10 year 3% bond for more than what you bought it for.
This is almost the same as the current housing market, for a different reason than interest rates. As the supply of housing inventory decreases in 2020 and 2021, the housing market becomes a sellers’ market. How can a house with no renovation (added value) get sold for $100,000 more? The answer is evaluation. The evaluation of homes at a lower inventory environment is higher than average levels.
With the same analogy, the price of a bond at a high interest rate environment is lower than the purchase price.
How do the bonds recover from lower evaluations?
Bonds will recover as the interest rates start to fall. Interest rate is one of the main monetary tools and economic drivers, which the government controls to direct economic activities. Interest rates will always move up and down, as it will form a bond cycle.
Bonds will also recover in time. As existing bonds mature, and bond holders purchase new bonds with the current interest rates, the overall bond portfolio will recover as a whole. This is mainly how a bond fund operates.
Now if you are holding a bond fund, or fixed income fund in your investment portfolio, you can understand the return cycle better. Keep in mind, a balanced portfolio also holds bonds within the portfolio. As the bond cycle interacts with equity and other markets, it will form a diversified investment portfolio.
A well diversified portfolio not only can protect against interest rates, but also inflation, geopolitical and many other market factors.