Kulo 101: Bonds, Explained

Nobody brags about bonds at a barbecue.

Nobody's cousin got rich on Treasury notes. No one has ever said, "Bro, you gotta get in on the 10-year." Bonds don't have a mascot, a meme, or a CEO who posts at 2 a.m.

And yet last week, the whole market stopped and stared at one bond number. The 30-year Treasury yield hit 5.64 percent. The 10-year hit 5.29 percent, its highest since 2007. Mortgage rates jumped to 7.28 percent, the highest in nearly three years.

So pull up a desk. Today we learn the boring thing that runs everything.

A bond is an IOU

That's it. That's the big secret.

When you buy a bond, you are lending money. The borrower promises to pay you a little interest along the way, then pay you back in full on a set date.

You are not the borrower this time. You are the bank. Congratulations on your promotion.

Who borrows? Governments, cities, and companies. The biggest borrower on Earth is the U.S. government, which sells Treasury bonds. It's the only borrower in the world that can print the money it owes you. That makes it the safest IOU you can buy, which is why the whole financial world uses it as the measuring stick for everything else.

Three words you need

Every bond comes with three things.

Face value. The amount you get back at the end. Usually $1,000 per bond.

Coupon. The interest rate the bond pays. A 4 percent coupon on a $1,000 bond pays $40 a year, usually in two $20 checks. (It's called a coupon because back in the day, bonds came with little paper slips you literally clipped and cashed in. Your great-grandpa did this with scissors. Finance used to be arts and crafts.)

Maturity. The date you get your $1,000 back.

Think of it like a car loan in reverse. Normally you borrow, make payments, and pay it off. With a bond, you're the one receiving the payments.

Short, medium, and long

The government sells three sizes of IOU:

• Treasury bills last from 4 weeks to 1 year.
• Treasury notes last 2, 3, 5, 7, or 10 years.
• Treasury bonds last 20 or 30 years.

When you hear "the 10-year" on the news, that's a Treasury note. When you hear "the 30-year," that's a Treasury bond. The financial news calls them all "bonds" anyway, because consistency is for amateurs.

The seesaw

Here's the one idea that confuses everyone, and once you get it, you'll understand half the financial news on Earth.

When interest rates go up, the price of old bonds goes down.

Why? Picture a yard sale.

You bought a bond last year that pays 4 percent. This year, the government starts selling brand-new bonds that pay 5 percent. Now you want to sell your old 4 percent bond.

Who's going to pay you full price for a 4 percent bond when the shiny new ones pay 5 percent? Nobody. Not even your mom. You'll have to knock the price down until it's a fair deal.

That's the seesaw. Rates up, old bond prices down. Rates down, old bond prices up.

And the "yield" you hear about on the news? That's the scoreboard: what a bond actually earns at today's price. When prices fall, yields rise. They're two ends of the same seesaw.

Why long bonds melt faster

In our October series, we called short-term bonds the fun-size candy bars and long-term bonds the king-size bars. You get more candy with king-size, but they melt faster when the house gets hot.

"Hot" means rising rates. Here's what that looks like in real numbers.

Say you own a $1,000 bond paying 4 percent. Then rates jump to 5 percent. Here's roughly how much your bond's price drops:

• A 2-year bond loses about $19.
• A 10-year bond loses about $78.
• A 30-year bond loses about $155.

Same rate change. Very different damage.

Why? Because you're stuck with that lower 4 percent for longer. Being stuck with a bad deal for two years is annoying. Being stuck with it for 30 years is a lifestyle.

The good news: if you hold the bond until it matures, you still get your full $1,000 back. The price drop only hurts if you have to sell early. The seesaw moves the price. It doesn't change the promise.

Why your mortgage follows the 10, not the 30

This is the part that should make your neighbors think you're a genius.

A 30-year mortgage does not follow the 30-year Treasury. It follows the 10-year.

Why? Because almost nobody keeps a 30-year mortgage for 30 years. People sell the house, move for a job, or refinance when rates drop. Lenders know most mortgages are paid off within about 10 years. So they price them off the 10-year Treasury.

Then they add a little extra on top, called the spread. That covers the risk of lending to you instead of to the government. (No offense. The government just has a printing press, and you have a Honda.) That spread has historically run about 1.5 to 2 percentage points.

So here's the rule. Write it on your fridge:

Watch the 10. Add 2.

Last week the 10-year hit 5.29 percent. Add 2, and you get about 7.3 percent. The average 30-year mortgage? 7.28 percent.

On a $300,000 home loan, today's rate costs about $188 more every month than a year ago, when mortgages averaged 6.34 percent. That's about $2,255 a year. Same house. Same buyer. Different 10-year.

So the next time the news says "the 10-year jumped," you'll know what it means: somebody's house just got more expensive.

Why anyone owns these things

If bonds are this boring, why does anybody bother?

They pay you to wait. Every six months, a check shows up. No drama. No earnings call. No CEO tweets.

They usually zig when stocks zag. When stocks get scary, nervous money often runs into Treasury bonds. Not always, but often enough to matter.

They're the seat belt. You don't buy a seat belt because you plan to crash. You buy it because you don't get to schedule the crash.

Most people buy bonds through a bond fund, which holds hundreds or thousands of bonds in one package. Our own account holds two of them, one short-term and one that holds a little of everything.

And here's the twist for New Mexicans: you may already own bonds and not know it. If you have a 401(k), a target-date retirement fund, or a state or teacher pension, there are almost certainly bonds in there working quietly for you. And every time a city or school district borrows money to build roads, schools, or libraries, it does it by selling bonds.

Kulo's cheat sheet

• A bond is an IOU. You're the lender.
• Coupon is the interest. Maturity is when you get paid back.
• Rates up, old bond prices down. It's a seesaw.
• Long bonds swing harder than short bonds. King-size melts faster.
• Your mortgage follows the 10-year. Watch the 10. Add 2.
• Bonds are the seat belt, not the engine.

Not to predict anything. To not be surprised.

Kulo out. 🎓

🎓 Educational content only. Not financial, tax, or legal advice. The bond price examples are simplified illustrations, not quotes for any specific security. Talk to a licensed professional about your own situation.