Why Is Everyone Buying Bonds? The Mechanics of Bonds

Ethan
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BONDS EVERYWHERE

Have you noticed that everyone has been buying bonds? In fact, so many people have been buying bonds that the United States archaic bond buying website, treasury direct, has been crashing due to the traffic spikes. And it’s not just retail investors who want in either. 

In fact, retail investors only account for about 7% of the bond market’s trading volume. Aka, more than 90% of bonds are being traded by financial institutions and companies, and when you take a look at the balance sheets of some of the largest companies in the world, this makes a lot of sense. 

balance sheet of Apple


Take Apple for instance. They’re currently holding $34 billion in short term marketable securities and $104 billion in long-term marketable securities, most of which include bonds and other fixed-income assets. Similarly, Microsoft is holding $104 billion in cash, cash equivalents, and short-term investments. 

Even Facebook, who are generally the most willing to take massive risks like their $100 billion bet on Metaverse and $33 billion bet on AI, has been buying up bonds. In fact, as of their last quarterly report, Facebook was holding just over $53 billion in cash, cash equivalents, and marketable securities. 

facebook balance sheet


It’s not just these big tech companies that are investing heavily in bonds either. Some of the most legendary investors of all time, like Warren Buffett, are buying bonds hand over fist. In fact, Warren Buffett came into 2023 holding $95 billion in treasury bills alone. And as of August 2023, he was buying $10 billion worth of treasury bills every single week. So, why in the world is everyone suddenly buying bonds? 



BONDS EXPLAINED

Some of you are probably wondering: what exactly even is a bond? Well, bonds, just like stocks, are a way to invest in a company’s future. But instead of buying a piece of the company, bonds are a way to help fund the company. When you buy a bond, the money you invest will be given to the company, government, university, or foundation of your choice. 

These institutions will then turn around and use this capital to fund expansion efforts, research and development, public projects, new infrastructure, and whatever else they think would grow profits and revenue or serve the community depending on whether they’re for profit or not. And in return for helping them accomplish their goals, these institutions will pay you back with interest over a set period of time. 

Usually, you get an interest payment every quarter or every 6 months until maturity, at which point you get your initial investment back, which is generally $1000. To be honest, it’s a pretty simple system and that’s why it’s been around for millennia. 

In fact, bonds are arguably the oldest investment of all time dating all the way back to 2400 BC to the Mesopotamians. Instead of cash, though, bond investors back in the day were paid back with corn. If you’re a Shakespeare fan, you’ve probably also heard of the famous saying “a pound of flesh”. 

In Shakespeare's “Merchant of Venice”, the main character would essentially promise that if he doesn’t pay back his bond, the villain can take a pound of his flesh. The bond market has come a long way since those medieval days though. In fact, today, the bond market is the world’s largest securities market. 

The Global Bond Market


The US bond market is worth $51.3 trillion and the global bond market is worth $133 trillion dollars. For perspective, the global stock market is “only” worth $109 trillion. But if the bond market is so large and so established, why is everyone suddenly piling in right now? 



HYPE EXPLAINED

Well, the most obvious Hype Explained factor is none other than the high interest rate environment. After 15 years of keeping interest rates at near zero levels, the Federal Reserve has jacked up rates all the way to 5.33%. This has led to bond interest rates skyrocketing across the board. In fact, almost every day, we see headlines about how bond yields have just reached 16 year highs. 

In general, the U.S. government is paying 4.5 to 5.5% on treasury bills, notes, and bonds. Top companies like Apple, Google, Microsoft, and Facebook are paying 5-6%. And if you look close enough, you can even find investment grade bonds from companies like Kellogg's, Discover, Paramount, and Time Warner Cable that are paying 7-8%, and this right here is what’s enticing to a lot of investors. 

If you didn’t notice, that’s nearly the same return as the S&P 500 over the past 50 years which is generally the benchmark for gauging investment returns. Now, investors are able to get nearly the same yields as bonds, which are in general far less volatile and more reliable than stocks. 

Now, let me preface by saying that there is no such thing as a risk free investment. All investments carry risk, that’s kind of why they generate a return in the first place. But on the spectrum of risk, U.S. government bonds are as close as you’re going to get when it comes to minimizing risk. 

In fact, the only time that a financial institution is allowed to describe an investment as risk free is when they’re referring to treasury yields. Treasury yields are considered “risk free” because they’re backed by the US federal government who in theory can just print money to pay back bond holders. 



So, when investors are able to lock in 5% yields not just for as long as their savings account pays high interest but for the next 5, 10, 20, 30 years with the federal government, it’s no wonder why so many investors like Warren Buffett are taking the plunge. 

But it’s not just about locking in high rates. For many investors, buying bonds has to do with protecting against inflation. Of course, you’re gonna fare a lot better against inflation if your cash is growing at 5% but there’s actually an even more interesting way to protect against inflation from the federal government themselves and it’s called TIPS or Treasury Inflation Protected Securities

Unlike traditional bonds where you lock in a specific yield when you buy, TIPS have a variable return that’s directly linked to inflation. The value of the bond essentially rises with the current inflation rate. So, if we were to have a year where there was 9% inflation, the value of the bond would also rise by 9% that year. In the off chance that there’s some deflation, your bond value stays the same. 

Obviously, this doesn’t provide any real return, but it ensures that your cash isn’t being eaten up by inflation either. Hearing all these factors alone, I think you can piece together why all of these big investors and companies are buying bonds. But when you combine this with a stock market slump, well, all of this just goes into overdrive. 

In fact, 2 year treasury yields are almost equal to the S&P 500’s trailing 12 month’s earnings yield. So a lot of investors are simply migrating from stocks to bonds. But if the bond market is so large and so established, and now also really appealing, why do we as retail investors never hear about bonds? THE 



HIDDEN MARKET

Well, the mainstream answer is that interest The Hidden Market rates have simply been low over the past 20 years, rendering bonds not that attractive, but honestly, this is a BS answer because companies and institutions never stopped investing in bonds. Sure, they hold more bonds now than ever, but they were already holding tens of billions if not hundreds of billions of dollars worth of bonds even during low interest rate periods. 

US corporate bonds graph


Here's a graph of how the US Corporate bond market has grown over the past 40 years. As you can see, it’s just been straight up regardless of interest rates and this makes perfect sense if you subscribe to the efficient market hypothesis. The efficient market hypothesis states that security prices reflect all known information at any given time. 

This means that if bonds truly were unappealing at some point in time, the market would simply sell off until bonds reached a normal level of desirability. Similarly, if bonds truly are underappreciated right now, the market would simply buy up bonds until a normal level of desirability is achieved. And this doesn’t just apply to bonds or even just investments in general. 

It’s the same thing with grocery prices and restaurant prices and tuition prices and basically anything else that’s governed by the forces of supply and demand. While something may be overvalued or undervalued at a given point in time, over the long term, all investments maintain an equilibrium between themselves. 

In other words, if you’re choosing between bonds and dogecoin, there is no objective winner. Each investment is equally desirable and their respective returns are simply in line with their respective risk. This is why companies never stopped investing in bonds. Bonds simply always had a place in their portfolio just like high risk acquisitions and the Metaverse. 

But if that’s the case, why are bonds so unpopular with retail investors? Well, I think this has more to do with optics and the goals of brokerages as opposed to the desirability or undesirability of bonds. Here’s the thing, if you were a brokerage, what would be easier to pitch? 

Invest $100 into this hot new NFT and have a chance at making $10,000 in 2 months or invest $10,000 into this treasury bill and reliably earn $500 a year. It’s obviously the former. Sure, it might sound a bit sketchy, but at the end of the day, it’s only a $100, so many people just treat it as a sort of lottery ticket as opposed to methodical investing. 

If you've ever watched Wolf of Wall Street, you might remember the scene where Jordan Belfort tried to sell a penny stock called "Aerotyne International" by describing it as a "cutting edge high tech firm" that was "awaiting patent approval" and that a "6,000 investment would turn 60,000". While brokerages aren't nearly as predatory, this shows you a bit more about where their interests lie when they’re pushing stock trading, options trading, crypto trading, forex trading, futures trading, NFTs, web3, you name it. 



For modern brokerages, it’s simply been a lot easier to entice people with high returns than solid investing principles. Also, not only has it been easier to entice people with high returns, it’s also been more profitable. For obvious reasons, people constantly trading a bunch of stocks, options and crypto is a lot more profitable for brokerages than people buying a bond and holding it for 2 years. 

So, in the name of maximizing users and revenue, brokerages have largely sidelined bonds over the past few decades. But don’t be fooled, the biggest companies in the world aren’t throwing trillions of dollars at doge coin, they’re throwing it at bonds. I would encourage you to research bonds because it’s more than likely that these companies know what they’re doing. 

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