Key Takeaways

- The bond market sets the price of money across the entire economy: when rates rise, credit, investment and government funding become more expensive.
- A surge in inflation causes the value of existing bonds to plummet and forces investors to demand higher yields.
- When the bond market tightens, equities often end up suffering in turn: money becomes more expensive, growth slows and stock valuations come under pressure.

First, one must accept a counter-intuitive truth: a bond is not complicated. It's a loan. All companies and states need money. This money is borrowed from investors in exchange for a promise to repay them in a few years and to pay them annual interest in the meantime. This interest rate is called the coupon. That is it. The trouble begins when inflation enters the room.

The relentless mechanics of rates and prices

Suppose a state borrows at 3% over ten years. Investors who buy this bond receive €3 per year for every €100 lent. This annual payment is the coupon. However, imagine that, a few months later, inflation jumps from 2% to 5%. The holders of this bond continue to receive their €3 per year. The problem is that with inflation at 5%, those €3 have lost part of their real value: the yield is no longer sufficient to compensate for rising prices.

The market will therefore demand more to lend over ten years. Newly issued bonds might offer 5% or 6%. Consequently, the old 3% bonds become much less attractive. Not because they stop paying, but because they yield less than the new securities available on the market.

This is where the mechanics that often baffle the uninitiated come into play: a bond's coupon never changes, although its price fluctuates constantly on the secondary market, where investors trade already issued bonds. For an old 3% bond to remain attractive compared to new 5% bonds, its price must fall. If it is no longer worth €100, but rather €85 or €90, the €3 annual coupon then represents a higher yield for the new buyer. This is how the market rebalances: when bond prices fall, their yields mechanically rise.

Another factor amplifies this mechanic: duration. The longer a bond's maturity, the more sensitive it is to rate fluctuations. A two-year bond will generally suffer much less than a thirty-year bond if rates rise, because the investor is locked in for a shorter period with a yield that has become less attractive. This is why fund managers closely monitor the average duration of their portfolios: when they anticipate a rate hike, they often seek to shorten it to limit losses.

Consequently, these managers never stand still. They constantly arbitrage between old bonds and new issues on the primary market, adjust the average duration of their portfolios, sometimes reduce their exposure to long-dated bonds, or favor floating-rate notes. Their job consists precisely of trying to anticipate rate movements before they destroy value in their portfolios.

Contagion to the wider economy

What happens next is the reason why everyone should take an interest in bonds, even those who hold none. Bond yields serve as a benchmark for almost everything. Your mortgage rate is not set in a vacuum: it depends, directly or indirectly, on government bond yields. When the latter rise, your banker charges you more. Companies also borrow at higher costs, thus investing less and hiring less. States see their debt service burden increase, which reduces fiscal leeway.

Rising bond yields represent a sort of general tightening of financing conditions for the economy, diffuse yet powerful. This is precisely why the 2022-2023 period was so brutal. After years of near-zero rates, post-Covid inflation forced central banks to raise their policy rates at an unusual speed. The bond market suffered one of its worst years in decades. Seasoned managers lost money on assets that their clients believed were risk-free.

The great misunderstanding of bond safety

This touches upon one of the most widespread misunderstandings in finance. Bonds are often presented as the safe investment, the conservative portion of a portfolio. This is fundamentally true: if you buy a bond from a solid state and hold it until maturity, you recover your principal and your interest. The default risk is low. But between purchase and maturity, the market value of that bond can fluctuate considerably. An investor who must sell before the term in a rising rate environment can incur a very real loss.

The bond market has not regained its serenity. In many developed countries, public deficits remain high, meaning that states must continue to issue large volumes of bonds to finance themselves. The more abundant the supply, the more yields tend to rise to attract buyers. Add to this an inflation rate that is slow to return sustainably to its target in certain regions, and you have a cocktail that keeps investors on edge. The bond market is often described as the true thermometer of the economy. When it overheats, rarely out of enthusiasm, equities often end up looking in its rearview mirror.