Most small investors only buy common stocks. But the New York Stock Exchange was founded in 1792 to trade bonds. Investors were speculating on the value of newly issued U.S. government bonds, created by Treasury Secretary Alexander Hamilton to combine Revolutionary War debts and build a banking system.
Speculators back then were betting on the price fluctuations of bonds, which directly impacted their yield.
How Yield Works
Let’s say I lend you $1 million to buy my house. You can’t get a bank loan, so I tote the note at 10% interest. This means you’re paying me 10% interest over the life of the loan, plus some of the principal. An online mortgage calculator indicates you’ll be paying me $13,215.07 per month for my money on those terms.
That $13,000 per month is income to me, giving the note value in the market. If that’s the general interest rate for credits like yours and I want cash now, I might get $1 million for it.
Many things can change that price. If you lose your job, or the value of the stocks you used as collateral falls, my loan is worth less. If you get a promotion, or the value of your collateral rises, my loan is worth more. This price also changes as the loan ages since the principal amount and the term of the loan are changing.
Government and Yield
When I turn your loan into a piece of paper and sell it, the paper is called a bond.
A bond’s value can also rise and fall when compared to the value of the very best loans — those backed by the U.S. government. As the interest rate the government is paying recently rose from 1.5% to 3%, the interest paid on mortgages rose from 3% to 5% and the value of this loan went down. If those interest rates reverse, the value of this loan goes up.
That’s how bond markets work. Each bond has a value, calculated against the original agreement. That agreement is called par for the note and each tiny bit is valued at $100. When interest rates drop or your credit gets better, the bond may be sold for more. When interest rates rise or your credit goes bad, the bond may be sold for less.
Multiply the value of the bond by the interest rate and you get its yield. If your credit gets worse and my risk goes up, the value of the bond may drop to $80. This increases the effective yield to a buyer of my bond to 12.5% since they’re just paying $800,000 for a $1 million obligation. The same happens in reverse if your credit gets better or the government’s does. Now the loan may be sold for $1.2 million, but its yield to the new purchaser is just 8%.
Bond Market Magic
This example isn’t theory. All sorts of loans have now been packaged into bonds and re-sold to big investors. You can buy packages of mortgages, car loans even personal loans. Financial technologies (fintechs), like SoFi Technologies (NASDAQ:SOFI), which are using investor equity to make loans, have seen their value crash as the value of this equity and the loans based on them has plunged. All bond yields change as their price does in relation to the specific risks of the loan and general interest rates.
What does this mean? As the Federal Reserve hiked interest rates, bond prices dropped and yields rose. Bondholders suffered losses, but the price drop also attracted buyers to the higher yields. Money thus moved from stocks to bonds. Your stocks lost value.
The first story I did as a business reporter 44 years ago involved a trader who made a pyramid of housing bonds. He bought a bond, got a loan for 90% of its value, bought a bond with it and got another loan. This worked great when interest rates were rising since the yield on each succeeding bond was high. When it reversed, the whole thing crashed on the trader and his customer. He was a modern-day William Duer.
You, too, might become a Duer after the current crisis is over. If bond trading becomes more transparent, making it as cheap for you to speculate on yields as you do on stock values, the next bond panic could be on all of us.
As it is, it’s mainly crashing on fintechs, traders and stockholders.
On the date of publication, Dana Blankenhorn held a long position in SOFI. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.