How Do Bonds Work? | DataDrivenInvestor

A friend of mine moved her 401K stocks into bonds at the end of last year because she thought a revolution was coming. While that assumption was not completely out of the realm of possibility, she unfortunately missed the market runup of the last year. Any good financial advisor will tell you not to try to time the market and I get that, but one should at least know what is going on. And to do that, you need to know how bonds work and how they relate to stocks. To her credit, my friend called to ask me how bonds work.

Let’s start with a bit of basic housekeeping:

Bond yields have a negative relationship with bond prices. Bond yields have a positive relationship with the stock market.

Easy peasy. But many people, even investors don’t understand why. Before I get to that, I’ll explain what a bond is.

Buying a Bond

Buying a bond is like loaning someone money. You pay them for the bond, called the “price,” and they promise to pay you back. It’s an IOU. If you buy a 10-year bond, they have to pay you back in full in ten years. In the meantime, they pay you interest. That is your payment for letting them have your money for ten years. That’s called the “yield” on a bond.