Transcription
There is a market worth over $100 trillion dollars that impacts your mortgage, your job prospects, your stock portfolio, and even the price of Bitcoin. The reality is a lot of people don't know how this market works. Nope, it's not stocks. No, it's not crypto. It's actually the bond market, and it's the most important piece of the global financial system.
So, what is a bond? Imagine you're starting a business. You've got an amazing idea. You've got all the drive in the world to make it happen, but you just don't have the money. So, you go to someone who does and you borrow it. You make them a promise. You say, "Hey, I'll pay you back and I'll give you a little extra on top." That little extra on top is called interest. That is the cost of using someone else's money.
A dollar today is worth more than a dollar tomorrow. Because if you have a dollar today, then you can use it to take advantage of opportunities as they arise. When someone gives you that money now, they're giving up that potential. So, they want to be compensated for that because otherwise they could have taken that same money and invested it in their own business or some other opportunity or even something like the S&P 500.
Now, people and companies often borrow money, but so do governments. And when a company or a government needs to borrow money, they do it by issuing bonds. That makes them the borrower or the issuer of the bond. And the investor is the lender.
The US government is always spending money, whether it's on defense, roads, health care, or social security and beyond. And while a lot of that may sound altruistic, in reality, it's also strategic. Governments spend to stimulate productivity because productive citizens and businesses generate tax revenues. Most of a government's revenues are going to come from taxes. So in the United States in 2022, 54% came from personal income taxes, 30% came from payroll taxes, and 9% came from corporate taxes, while the rest was from excise taxes and things like park fees and so on.
But here's the thing. The US government tends to spend a lot more than it collects in revenues. And that gap between what they collect and what they spend is called the budget deficit. And every time we run a deficit, we're adding to the total national debt, which is the amount that the government owes from all past borrowing. Deficits are annual. The total debt is cumulative. The last time the US government ran a budget surplus was in 2001, which I find surprising because it's a very different picture from where we sit today. In 2024, the US had a $1.8 trillion deficit.
So, where does the extra money come from? The US Treasury borrows that money from the public by issuing bonds. As the government needs cash, the Treasury holds auctions, selling bonds to investors all over the world, and people tend to buy them. Banks, pension funds, insurance companies, even foreign governments, and also regular American citizens.
Why do people show up to these auctions? Part of it is because US government bonds are considered one of the safest assets in the world. The day that the United States defaults on its debt would be a day where we probably have much bigger problems to deal with.
So, let's break down some of the terms around bonds. First, you have the principal, which is the amount being invested or the amount being borrowed. Then you have the coupon, which is the interest payment or the percent that you're going to receive on that bond on a yearly basis. Then you have the maturity, which is when the loan is due or how long the investor has to have their capital tied up. Finally, we have the yield, which is the return that the investor gets from the bond.
And the reason that this is different from the coupon is because the price of the bond can change, which then affects the actual return. Bond prices go up and down, but the coupon, the dollar amount being paid on that bond stays the same. And so because of that, the yield can move up or down based upon the price of the bond. If the price of the bond falls, then the yield rises. And if the price of the bond goes up, then the yield will decline.
Let's say you have a $1,000 face value bond and that bond pays 3% which is $30 a year. A few months later, there are bonds that get issued at 5% for $1,000. So paying $50, the bond that you previously bought paying $30 is now less attractive on the secondary market. So the price may drop to let's imagine $900, but you're still getting that same $30 coupon on that bond. So now if you take that $30 and you divide it by the current price of $900, now you're sitting at a yield of 3.33%. The opposite is true if rates were to fall. In that case, bond prices would go up and the yields would go down.
So where do these market-based interest rates come from? Treasury auctions are one piece of that puzzle. The government sells bonds on a set schedule, weekly, monthly, depending upon the maturity of the bonds that they're selling. And the yield at auction depends upon how much demand there is at that auction for these bonds. This is called the primary market. When new treasury bonds are auctioned in the primary market, the yield at which they are sold becomes a benchmark and investors in the secondary market look at this yield to reassess the value of similar bonds already in circulation.
Investors are constantly buying and selling based on their expectations. Will the Fed hike or cut rates? Is the economy speeding up or slowing down? Do we expect inflation in the future? These are the kinds of questions that bond investors ask themselves to determine what yield makes sense for them to lend their money out at. The result is that the market interest rates are really just the yield that global bond investors are demanding at any moment in time. It's all based on what they think the future holds.
Now, here's where things get interesting. Because if market rates go up, then the cost for the government to borrow also rises. Right now, the US government has over $36 trillion in national debt that they have borrowed from the public over time. The key ratio to watch to get an understanding of what that debt really means is called debt to GDP. It's a way to look at how much we owe versus how much we produce. It's kind of like how much do you have in your credit card balances versus how much is your annual income. This can kind of give you a better idea of how healthy that debt is or how likely the person is to be able to pay off that debt within a certain period of time.
But what's even more important is at what rate are we paying interest on that debt? Because when rates go up, then the government has to spend more just to cover the interest payments. And that burden can grow fast. Because right now, a lot of government debt is in short-term treasury bills. These treasury bills are constantly resetting because they mature in time frames like 6 months, 12 months, and 18 months. So, the government is constantly using these short-term treasuries to fund their borrowing. This process is called rolling over the debt.
What the government would like to do, as we're seeing in the news, is to get rates lower so that instead of using these short-term Treasury bills to fund their borrowing, they can then lock in a lower rate for longer-term bonds like 30-year or 10-year bonds. When you want to borrow over a longer period of time, you want the rates to be lower. When rates are high and you borrow in the long term, it's like setting in your mortgage rate at 7%.
Here's something that we have to think about. Every 6 to 12 months or so, we have these short-term obligations that the government is then refinancing again, but also you have older borrowing that was done in the past over say 10, 30-year periods. That's also now constantly coming up. The government is taking what was once long-term debt and rolling it over into these short-term maturities. And as that happens, more and more of the total debt burden is relying upon present-day market interest rates. If rates were to rise, then so will the cost of interest on the debt. And as that happens, it starts to crowd out the spending on other things like defense and healthcare. That sometimes will lead to cutting expenses or even continuing to borrow more heavily to find ways to fund these obligations. And that's why bond yields matter. Not only does it impact your mortgage, but it also shapes the financial future of entire countries.
There's more to this that's going to impact your stock portfolio. So pay attention. When interest rates rise, government bonds essentially are offering a better return with no risk. Now, on the other hand, stocks are ownership in a company, not an obligation for a company or someone to pay you over a specific period of time. So, if that business struggles or even if the economy slows, then the price or the value of that stock can go down and even down to zero. Bonds are very different, especially US treasuries, because the only way that you don't get paid is if the government defaults. Otherwise, you're going to get your money back with interest.
So, when treasuries start offering 5%. And stocks have an expected return, let's say, of 6%. Then investors are going to ask themselves, am I really going to take the risk of buying a stock that's going to give me 6% when I can get a guaranteed 5% from the government? That interest rate for government bonds is called the risk-free rate. And the 1% spread between the expected value of the 6% from the stock market and the 5% from the government bond is called the equity risk premium. When bond yields rise, that premium shrinks. And as that happens, investors start to rotate out of stocks or sell them.
Now that was the equity risk premium which is the difference between the risk-free rate from the government and what investors would need from a stock in order to justify taking that extra risk. You have a similar concept in the bond market and specifically between government bonds and corporate bonds. When fear in the market rises, investors demand higher interest rates from the corporate bond market. Companies tend to have different credit ratings and a real potential to actually go bankrupt. The gap between safe government bonds and risky corporate bonds is called the high yield spread. When that spread widens, it's usually a signal of some sort of trouble in the markets.
The bond market doesn't just reflect economic reality, it also shapes it because as interest rates rise, it can start to slow down the entire economy. One more thing, the yield curve. Normally, longer-term bonds are going to pay more than shorter-term bonds because locking up capital for a longer period of time is going to have a larger opportunity cost as things continue to change and your money's tied up in a bond. But when short-term yields are higher than long-term yields, then you have what is called an inverted curve. When the yield curve inverts, investors are basically saying they prefer long-term bonds compared to short-term bonds because they're expecting either an economic slowdown or another reason for rates to decline in the future. The increased demand for the long-term bonds pushes the yields of those bonds down.
Later in this series, we'll talk about how the Fed and the Treasury interact with one another to influence the yield curve. Check out the next video.