The Bond Book
By Annette Thau
If you want to learn about bonds and treasuries but don’t know where to start, this book is that starting point. I follow the markets pretty closely and I know the basics of Bonds, but I wanted to go further in-depth with my Bond knowledge. I started reading a different book about bonds but I was getting lost pretty quick. I decided to read The Bond Book to help me fill in the blanks on a few of the basics that I never really learned. I feel like this book was the perfect starting point before really diving deeper into more complicated aspects and calculations involving bonds.
I don’t directly trade bonds, but the bond market is a major part of our economic cycles, and so as traders we need to understand what is happening in the bond market. This book will give you the basic knowledge that you need to know to understand someone that is talking about the bond market. If you turn on CNBC and you hear a segment about the bond market, it’s nice to at a minimum understand what the conversation is talking about.
The Yield Curve
The yield curve is a topic that I was really interested in before starting this book. I have a much better understanding of what affects the yield curve now.
“The shape of the yield curve changes continually because interest rate expectations of the major users of credit (that is, large corporations and institutional investors) change constantly. If buyers expect an increase in inflation and a concurrent rise in interest rates, they seek the safety of short-term paper. As a result, short rates decline. If, on the other hand, they anticipate lower economic growth, recessionary times, and lower interest rates, they try to “lock in” high yields, which results in declines of long-term interest rates.”~ Annette Thau, The Bond Book
Types of Bonds
The Bond Book explains different kinds of bonds, such as those from the US Government (Treasuries), cities and states (municipals), government-backed mortgages (GNMAs), companies (corporates), and special bonds that don't pay interest until they mature (zero-coupon bonds).
Mortgage Backed Securities
Mortgage backed securities played a major role in the Great Financial Crisis of 2008. When reading the section about GNMA’s I realized that this was written shortly before that crisis. Thau did a great job explaining the risks that were involved with these types of financial assets, and although she didn’t predict the financial crisis, she did explain how it was a possible outcome.
Impact of Interest Rates on Bonds
The book also helps you understand how changes in interest rates affect bond prices. Thau shows that when interest rates go up, the price of bonds goes down. And when interest rates go down, the price of bonds goes up.
“The basic principle is that interest rates and prices move in an inverse relationship. When interest rates went from 4.78% to 6.75%, that represented an increase in yield of over 40%. The price of the bond declined by a corresponding amount. On the other hand, when interest rates decline, then the price of the bond goes up.”~ Annette Thau, The Bond Book
The Bond Book Main Topics
Here's a broad list of the topics discussed in this book:
- Basic Concepts of Bonds: Understanding what bonds are and how they work.
- Types of Bonds: Treasuries, municipal bonds, corporate bonds, mortgage-backed securities, and international bonds.
- Buying and Selling Bonds: Overview of the bond market, pricing, and commissions.
- Bond Funds: Open-end funds, closed-end funds, and exchange-traded funds (ETFs).
- Bond Market Dynamics: Interest rate risk, yield curve, and bond price volatility.
- Bond Yields and Returns: Fundamentals of bond math, yield, and total return.
- Risk and Opportunities: Understanding risks such as interest rate risk and credit risk.
- Credit Ratings: How credit quality affects bond value.
- Portfolio Management: Asset allocation, structuring portfolios, and managing interest rate changes.
Quotes From The Bond Book
Here's some quotes from the book that I highlighted while reading and that stood out to me in my second time reading the book:
Par, Premium & Discount Bonds
"The "par" value of a bond is its value at maturity; that is, $1,000. When a bond begins to trade, it normally ceases to sell at par. If it sells at less than par (less than $1,000), it is said to be selling at a "discount." If it sells at more than par (above $1,000), it is called a "premium" bond."
Basis Points
"Since institutional investors make or lose thousands of dollars on seemingly minute percentage changes, they have divided each percentage point into 100 points, each of which is called a "basis point" (bp). The difference between an interest rate of 6% and one of 7% is 100 basis points; between 5% and 6%, it is still 100 basis points. An increase in interest rate yield from 6% to 6.12% represents an increase in yield of 12 basis points (which would be recorded as 12 bp). ... Experience investors and salespeople think in basis points. It is far easier and more precise than using percentages. Using the term will immediately mark you as a knowledgable investor."~ Annette Thau, The Bond Book
Interest Rate Risk
"Why am I repeating this statement so many times? Because if nothing else makes an impression, but you learn that all bonds are subject to interest rate risk, regardless of the issuer or the credit rating or whether the bond is "insured" or "guaranteed", then this book will have served a useful purpose."
"The basic principle is that interest rates and prices move in an inverse relationship. When interest rates went from 4.78% to 6.75%, that represented an increase in yield of over 40%. The prie of the bond declined by a corresponding amount. On the other hand, when interest rates decline, then the price of the bond goes up."
"If you think interest rates are about to decline, buying bonds at the long end positions you for maximum capital gains."
~ Annette Thau, The Bond Book
Interest vs. Interest on Interest
Yield To Maturity (YTM)
"Current yield is based on coupon and price only. It ignores all other cash flows. Yield-to-maturity (YTM) takes into account all of the bond's known cash flows. It is only a projection, however. Your actual realized return is likely to differ significantly from the YTM because neither the price at which you sell (if you sell before the bond matures) nor the rates at which you reinvest coupons can be predicted at the time you buy the bond. The TYM should be used primarily to compare different bonds to each other before you purchase a bond."~ Annette Thau, The Bond Book
If you made it this far, the next book I would recommend following The Bond Book would be Mastering The Market Cycle, by Howard Marks. Understanding market cycles is a valuable concept if you plan on investing in the bond markets.