The Right Way To Think About Bonds

Speculating on the direction of interest rates is a popular sport in the bond market.

- James K. Glassman

But it’s proving a challenging one lately. The U.S. economy is perking along, and when that happens, bond interest rates usually rise. But not this time. For the first quarter of 2019, gross domestic product increased at an annual rate of 3.2%, compared with 2.2% in the fourth quarter of 2018. But 10-year bond rates actually declined—from 3.1% in mid May 2018 to 2.4% a year later. (Prices and returns are as of May 17.)

One explanation may be a disconnect between economic growth and inflation. Despite moderate-to-good GDP increases, inflation has been tame for seven years now, averaging just 1.6%. Or perhaps businesses and investors are expecting the economy to cool off. After all, this expansion is now the longest in at least 165 years, since records have been kept. And the consensus estimate of economists surveyed by Blue Chip Economic Indicators is for GDP growth of only 2.3% this year.

The reason bond investors fixate on where interest rates are headed is that bond prices move in the opposite direction of interest rates. Here’s why: A bond is an IOU, a promise that a borrower—the U.S. Treasury, Procter & Gamble, or the Three Rivers Park District in Minnesota—will pay you back on a set maturity date and, along the way, will pay you interest.

In almost all cases, those interest payments are fixed, in contrast with dividend payments from stocks, which the issuing company can vary at will. When a bond is issued, its rate, or coupon, is set by market forces influenced by three factors. The first is maturity, or how long the borrower can keep the loan before returning the principal; investors—lenders in this case—want higher rates for a longer term. The second is the danger of default, or credit risk. What are the chances that the borrower will get into trouble and miss interest or principal payments? The third factor is the