"What the heck is a bond, anyway? Dumb it down for me!"
Fair warning up front. If you hate math and finance and how money works, STOP! This will be 10 minutes of your life you’ll never get back. Don’t read any further; X out of this and go check out the latest Taylor Swift news or look at college football scores. Or the newest reason everyone hates Sydney Sweeney.
But if you've been wondering what the big deal is with interest rates and want to understand how money works, bonds are the best way to do that. In fact, to really understand money itself, understanding bonds is a pre-requisite. Don’t worry though, I’ll put it in plain language simple enough even Pittsburgh Penguins fans will be able to comprehend it. Just kidding guys—I don’t mean to denigrate Penguins fans. (And, if you are a Penguins fan, denigrate means “to put down”).
Everything costs money. Even money. Money isn’t free. I think we all know that; if it were free, we’d all have a lot more of it. But we don’t think of money having a dollar price. But it sure does. There’s a monetary cost to money itself. You can see this clearly in your spousal survivor annuity benefit when you go to retire. You know how you can choose 25% or 50% for your spouse to get if you pass away? They get 25% or 50% of your annuity? That’s their benefit. But you know what, that isn’t free. That costs money. Specifically it costs YOU money. So how much does it cost?
Well, if you elect 25% benefit for your spouse, it costs you 5% of your annuity. If you elect 50% for them, it costs you 10% of your annuity every month. That’s the price of the money you’re buying. If they end up getting $2,000 a month after you shuffle off this mortal coil, it’ll cost you $400 a month while you’re living. You can look at it this way: You’re buying $2,000 for $400. You are buying money with money.
Survivor annuity benefits always cost 20% of the benefit. (5% is 20% of 25%. 10% is 20% of 50%). The “price” of money is 20% for a survivor benefit. That’s kind of expensive when we’re talking about buying money, but that’s a discussion for another day. I’m just using this as an example to prep you for the bond discussion and buying money.
Enter Margaritaville.
Governor J. B. has decided that the municipality of Margaritaville needs a new bridge. It seems all the drunk tourists are constantly crashing into it. It needs to be repaired and upgraded. Margaritaville doesn’t want to spend its modest savings account to build the bridge. So it decides it’s going to issue bonds. It’s going to get loans from the public to pay for the bridge. When a municipality issues a bond, these are called (wait for it) municipal bonds. If you wear a Patagonia or Peter Millar vest cause you fancy yourself a finance bro or a finance bra, then you shorten this term to “Muni Bonds”. That’s the hip way to say it. Sick. Lit. Dope.
Anyway…. these bonds used to be actual paper certificates. (Anyone ever get a savings bond in the 80’s for your birthday from your grandfather? “Oh great! I wanted a Millennium Falcon and I got a piece of paper with $50 on that I can’t even buy anything with!”). For much of history, bonds were actual paper certificates. And in most cases, the terms of the bond were printed on it. And I use the word terms intentionally. Because this bond is in essence a loan contract and there are always terms to every loan, right? (Remember the 5,000 pages you signed at your house closing?) You are taking your money and loaning it to Margaritaville. You don’t do this for free. You do it to make money. Margaritaville has to pay you extra money to get you to give them some of yours right? That’s their cost of money. They pay money to get money. Remember our survivor annuity example? We refer to this cost of theirs as interest. They will pay you interest on your loan. And that interest is set. Let’s take a look:
Margaritaville Bond
Principal: $1,000
Coupon Rate: 7%
Maturity: 5 years
These are the terms of the bond. When Margaritaville issues the bond, they are “selling” it at $1,000. The principal or face value of the bond is basically the original loan amount. You are “buying” this bond, but technically you are just loaning them the money.
(This is the big difference between a stock and a bond. When you buy a share of stock you are actually purchasing a share of that company. You have become an owner. A teeny, tiny one, but an owner nonetheless. You own the right to profits and other assets. You have bought into the company and have certain shareholder rights. You don’t do that with a loan. You don’t own anything, other than you’re now a creditor so you have a claim. But you aren’t part owner in anything.)
How long are you loaning them the money? There are bonds with all kinds of terms. 1-year terms, 10-year terms, and for government Treasury Bonds, 30 years if you want. And everything in between. In our Margaritaville example, the term is 5 years. The bond matures, or returns your initial loan amount, at the end of 5 years. You are giving Margaritaville $1,000 for 5 years. They’ll give you your $1,000 back at the end of 5 years.
What do you get for that?
They will pay you 7% interest every year on your bond. That’s the coupon rate. The finance world uses weird terms that can sometimes make it difficult for mere mortals to understand what they are talking about. Luckily you have me. In most cases, there is a reason for the term. Why wouldn’t they just say “interest rate”? Because back in the old days, these paper bond certificates had little pieces of perforated paper attached to them and that’s how you got your interest. You tore off one of these coupons and took it to the company or the bank and they paid you your interest for the year when you turned it in. That system is long gone. You can see the potential problems with this. (Even the antiquated TSP wouldn’t even do something like this!). Now bonds are automated. The old world “coupon” reference remains, however.
So, in summary, you will loan $1,000 to Margaritaville for 5 years, and they will pay you 7% interest each year, then they will pay you back your $1,000 at the end of 5 years.
What do we make on this investment then?
Well, 7% of $1,000 = $70. We will make that 5 times-once a year in this case. That’s $350 that we will receive in interest over the 5 years ($70 x 5 years =$350). We will also get our thousand bucks back at the end. Thus, the entire transaction is this: We give Margaritaville $1,000 today, and over the next 5 years, we will receive back a total of $1,350. $1,000 of our original money plus $350 of interest in each of the next 5 years.
We didn’t get rich. We were never going to strike it big. We didn’t have the ability to double our money. We also didn’t really have the ability to lose half our money either, though. (Assuming Margaritaville doesn’t go broke or stop paying us). We made a nice, quiet, boring 7% a year on our money with little risk (compared to the stock market). Boring 7% ain’t nothing these days. Not when the market’s averaging 15% a year! But during some parts of financial history, a boring 7% would have been cause for intense celebration! If you got 7% return in 2008 when everyone lost 30% or 40%, you would have seemed like a financial genius.
This is why you see more conservative investors going after bonds. They pay a tidy bit of money and have only a little bit of risk. Think of the old people driving their Buicks 10 mph under the speed limit in the left lane, on their way to a bridge game and then the 4:30 dinner special. They are making decent money on their investments and protecting the principal (at least that’s their current goal.) Aggressive accumulation is no longer their goal. Preservation of their money is now more important.
Bonds have their place for certain segments of investors.
Easy enough?
That’s bonds.
Want to make it complicated? Here we go.
Now, let’s say after a year or two, you want to sell your Margaritaville bond. You don’t want to wait until the end of 5 years. Maybe you need the money. Maybe Margaritaville is not the best investment you once thought it was. Maybe now the mere thought of tequila makes you throw up. Who knows. Regardless, you want out.
So you go to sell your $1,000 bond. But you don’t find many takers. You talk to your financial advisor down at Crosby, Stills, Nash and Young. He tells you he can’t get you $1,000 for that bond. You tell him you pay him good money and he darn well better! But he pushes back and says the best the market can do on that bond today is $950. That’s not good for you. You paid $1,000 and now you have to sell it for only $950. What was the cause of this??
Well, now we get into a very contemporary issue we are experiencing as I type this in October of 2026:
Rising interest rates.
Let’s say that interest rates have gone up. Because interest rates have gone up, the cost of borrowing money has gone up, right? Just take a look at mortgage rates. You can’t get a 3% mortgage anymore in 2026. The cost of borrowing is up. You now have to get a 6.5% mortgage. The same works for the companies. They can’t issue bonds at 7% anymore. They have to pay more money to borrow just like us. So now companies might be issuing bonds at 8%.
8%!! Wait just a minute, that hurts our Margaritaville bond! Why would someone buy our bond at 7% when they can go out and buy other bonds paying them 8%?!?!? Maybe Margaritaville has needed more money and has even issued their own new bonds at 8%! That really hurts us since we are now holding a less desirable bond. Who wants 7 when they can get 8?
So because no one wants to buy our $1,000 bond at 7%, when they can buy $1,000 bonds at 8%, we have to make our bond more attractive. We have to sell our bond at a discount. Let’s say $950. At $950 maybe we have some takers. Why? Well, here is where bonds get really confusing, but understand this and you understand money. The yield on our bond changes. It goes up! Not the actual 7% coupon rate. We will always get that on our money, but the effective yield on our bond has changed.
Remember the terms of the bond? Margaritavlle will pay 7% on $1,000 a year, or $70. That doesn’t change. They will always pay $70. However, that $70 only equals 7% interest rate if we paid $1,000 for it. $70/$1,000 = 7%.
What if the next guy pays $950 for our bond? It’s he making 7%? No. Why not? Because he’s still getting $70 a year on the bond. Remember that part doesn’t change. But he only paid $950 for the bond. So now he’s making $70 on $950. How much is that? $70/$950 = 7.4% (rounded). The new yield on the bond is 7.4%. He’s actually getting a higher yield than we were getting if we sell this bond to him because he’s paid less than $1,000 to get the same $70.
Bonds get bought and sold like stocks, and not always at the initial issue amount. So because the interest paid is a fixed dollar amount, and the price or value of the bond can change, then the numerator is always $70 in this case, but the denominator changes ($1,000; $950; whatever) so that changes the yield. We were getting $70 on $1,000. He is getting $70 on $950.
As you can see then, the weird part of bonds is explained in the preceding paragraph: The price of bonds changes inversely to the yield. If the price of the bond goes down, the yield goes up. If the price of the bond goes up, the yield goes down. They move in opposite directions.
Let’s say interest rates fall. We go back down to 3%. Most people can only get 3% on their bonds they are buying. But we have a Margaritaville bond locked in at 7%. I bet people would pay even MORE than $1,000 for that bond if they can get more interest on their money. What would their yield be if they paid $1,100 for that $1,000 bond? $70/$1,100 = 6.4% (rounded). They’ll gladly take 6.4% on an investment if everything else is at 3%. So that’s how you get yield prices on bonds. The yield constantly changes based on the current market price of the bond. (By the way, this phenomenon is called the bond selling at a premium, i.e. more than the face value.)
Fast forward to the end of the 5 years. The bridge is built, Margaritaville has money, they pay all the bond holders back (whoever is actually holding the bond at the end). They give them back $1,000. No more and no less. When the bond was issued, that’s the money Margaritaville received. That’s all they’ll pay back. So if someone bought our bond in say, Year 3 for $950, then not only did they get a higher interest rate for a couple of years, they’ll make some gain money on the bond redemption since Margaritaville will give them $1,000 back, even though they only paid us $950 for the bond. So they get a little extra kicker of $50 in gains, in addition to whatever interest they received.
For the 1% of you that have put up with my ramblings this far, congratulations, you understand how bonds work.
What can we learn from the above? What generalities can we extract from this that might help our investing?
If you put thousands of bonds together, you have a bond mutual fund. This would be very very similar to our TSP F Fund. They’ve packaged thousands of bonds together. But the overall principle still works. It just works on the group instead of the individual bond. That’s why you see the F Fund go down when interest rates are rising. The value of the bonds are worth less since people can go buy newer bonds with higher interest rates. So why would they want our old crappy bonds in the F Fund that pay the lower rates? See the example above. As I write this, the F Fund is down over 2% for the year so far. Totally understandable. Not a mystery to anyone that understands the cost of money.
The opposite is true for the F Fund just like in the example above when interest rates went down and the price of our Margaritaville bond became more valuable ($1,100), because we have higher interest rates locked in.
Bonds are typically more conservative than stocks. You aren’t going to double or triple your money in 5 years. You also probably aren’t going to lose 30% or 40% in some crash. As a result, the older and more conservative you get, the more you should be in bonds as a general rule. This is why you can look at the L Funds in TSP and see how every quarter as we age, they move money from the C, S, and I (stock funds) to the G and F (bond funds). That is understandable and appropriate.
An important part of your investment research when buying a bond is the solvency of the lender. Who is promising to pay you back? Is it someone that actually CAN pay you back? Like a state or government, or large, established corporation? Or is it some tech startup that might not be around in 5 years? Those are important things to consider. While bonds are generally more conservative than stocks, you can go out and buy a bond from a company that has far more risk than buying stock in say, Coca-Cola, or some other established company. So a bond can be riskier, but generally speaking, bonds are less risky than stocks.
As you can see, as interest rates rise, bonds become a bigger part of the conversation. Who cares about interest when all you can get is 1% interest on something? No one. That’s why stocks have been all the rage since 2008. But….at one point in the 1980’s, government bonds were paying 15%. Nowwww we might be on to something. Who wouldn’t want to lock in 15% for 30 years in a government treasury bond? I distinctly remember my Furman-educated great uncle explaining this to me at 10 years of age, on the front porch of our home in Lancaster, SC. He took great pains to lay it all out to me, despite a 60-year age difference. If interest rates continue to rise, some of us might be interested in locking in investment opportunities at high rates, particularly if they are in their autumn years….
My personal favorite… municipal bonds are generally tax free at the federal level. I bought some last week. If I can get 6% or more tax free, I’m interested. Very interested. Particularly as my tax bracket goes up. Something to consider….