Note to my readers: The articles on Alex Trueba’s account aim to help you understand various aspects of finance for better decision-making, and, more often than not, simplicity requires leaving details behind. The goal is to understand concepts, not to make a masterclass in economics or finance. The examples use simple numbers and don’t reflect current market data because the aim is to be practical, global, and as evergreen as possible.
This will get a little complex; I have done my best to explain it in simple terms, but it still has a lot of considerations, so it’s a bit longer than my usual deliveries. Please take your time and read carefully; I assure you, it's worth it.
In our previous article, we saw how loans work between a single borrower and a bank. But what happens when a loan is sliced into thousands of pieces and traded across global markets? That is the bond market.
Market Conditions
Before moving forward to bonds, let’s briefly talk about “market conditions”; it’s important to grasp this concept. You’ve probably heard bankers and people in the industry use it frequently, almost like a disclaimer. And, in some respects, it is. It’s common to hear a banker pitch an opportunity to a client, and at the beginning or end of the conversation, they will say, “under current market conditions.” This refers to the state, environment, and characteristics of financial markets and the broader economy at a given point in time; it also encompasses investor behavior, liquidity, and asset prices. Why is it used so frequently? In an industry as complex and timing-dependent as finance, it’s almost like saying “all other things remain equal.”
Example 1: Market conditions.
Imagine you are selling your car and offering it at “x” price. All of a sudden, a new COVID-like crisis hits and damages supply chains so badly that the used-car market skyrockets, as the supply of new cars will be nearly nonexistent in the near future. After hearing this news, someone calls you to buy your car at “x”. What will you do? Very likely you will say something like, “Hold on, the market has changed so much since I originally set the price for my car.” And you will likely increase the price to “y” or stop offering it until you have a clear understanding of the real impact of the new situation. In simple terms, your original price depended on market conditions.
Now imagine a banker pitching a sophisticated financial product to a client, where conditions can change by the minute, or even by the second. It’s not surprising to use the phrase “under current market conditions,” after all.
Bonds
Let’s start with two definitions: securities and bonds.
Financial market securities: Tradable financial contracts that hold monetary value and represent ownership, debt, or rights to underlying assets. Let’s unpack this definition briefly: tradable means these assets have liquidity under market conditions (meaning you can buy or sell these securities in the open market under certain conditions); hold monetary value means there is an underlying economic value to the asset (which is not the same as the value it will hold over time, as this will depend on the issuer’s financial health and market conditions); and they represent ownership rights to equity or debt, or other types of rights (such as derivatives).
Bonds are fixed-income debt securities (which can pay fixed or floating coupons - SOFR, TIIE, or other benchmark rates plus a spread) in which investors lend money to the issuer (governments, companies, multilaterals, financial, non-bank financial institutions, and others) for a defined period, in exchange for interest payments and the promise of receiving the principal back at the bond's maturity.
The terms of these bonds are known to the general public, as this is a “public” arrangement available to anyone willing to buy, or even buy a small portion of the bond issuance.
Compared with loans, bonds have similar components: the issuer is the borrower, and investors are the lenders.
Aggregate Principal Amount: It’s the total face value of the original offering, similar to the principal on a loan.
Maturity date: The bond’s expiration date, when the issuer repays the principal if everything goes well.
Coupon rate: The interest rate paid to the bondholder on the coupon dates.
Coupon dates: The frequency at which the interest is paid. In the US, coupons are commonly paid semi-annually or annually. In Mexico, you'll see variation: some bonds pay every 28 days; others pay semi-annually. Also, there are bonds called “zero-coupon”, meaning there is no actual payment of interest until the maturity date, together with the principal. They’re usually bought at a discount and repaid at face value.
Amortization: Some bonds are “bullet” and pay the total principal at maturity, while amortizing bonds pay the blended interest plus a portion of the principal at each coupon. Needless to say, structure-wise, the former have higher risk than the latter. Mortgage-backed securities are a great example of an amortizing bond, where principal collected from the mortgages is passed on to investors.
So far, in an imperfect comparison, loans and bonds share similar characteristics. Bonds are versatile instruments that provide issuers the flexibility to reach large pools of investors, and for that reason, there are considerations to make this happen.
Face Value: The main idea of a bond issuance is to have as many investors as possible participate. For this reason, it is broken down into individual bonds. Face value is the original value of each bond. In the US, it’s $1,000 (par). An issuer can issue at a premium (above par) or a discount (below par), affecting the cash paid for the bonds on day one, but let’s leave it at that for now.
If a large corporation issues $500 million of bonds at par, you can infer that there are 500,000 bonds in the market, each valued at $1,000 at the time of the initial offering. This breakdown attracts more investors and enhances liquidity.Outstanding value: On day one, it’s the same as the principal, but sometimes the issuer can “repay” part of the debt early (buy back the bonds from the market) or issue more debt (reopen the same bond). The outstanding amount is then the total value of debt in circulation at any given moment, which can be smaller, larger, or the same as the original principal (aggregate principal amount).
Yield to Maturity (YTM): The YTM is the total expected return if you hold the bond until it matures. On the day a par bond is issued, yield to maturity equals the coupon rate. YTM will vary as time passes and the bond’s price fluctuates, or if you buy a bond on the secondary market (after it was issued in the open market), but at the moment of acquisition, if you hold it to maturity, YTM will remain the same, assuming all coupons are paid on time and reinvested at the same rate. This last part doesn’t happen; it is simply a market convention to compare yields on equal terms.
Credit ratings: Rating agencies commonly rate bonds. These ratings reflect the issuer’s credit quality. Widely known names in the market provide this service, such as Moody’s, S&P Global Ratings, and Fitch Ratings. Different countries use some of these names, along with local providers. Mexico, for example, has HR Ratings and Verum. Canada: Morningstar DBRS; Europe: Scope Ratings (from Germany), among others.
This is a long conversation, and I don’t want to distract you right now; I plan to cover it in a future article. For now, know they exist, and bond pricing will be affected: the lower the credit quality (hence the lower rating), the higher the funding cost (coupon rate) at issue. Also, if an issuer’s credit rating is cut, its bonds will drop in price, and yields will rise. The opposite is true when an issuer is upgraded.
US Treasuries
US Treasuries (UST) are unsecured bonds with no collateral. Markets consider them risk-free assets with no default risk, as the chances of the US government failing to pay its debts are virtually zero; they are backed only by the full faith and credit of the US government.
The market rationale is that the US dollar is the world's reserve currency; the issuer borrows in a currency it ultimately controls; it has the constitutional power to tax the world's largest economy; and USTs are the world's deepest and most liquid financial instruments.
It’s also worth distinguishing between the market convention of a risk-free asset and the credit rating agencies' stance: the US lost its pristine AAA/Aaa rating across all major rating agencies and is currently AA+/Aa1 (at the time this article was written).
Companies’ bonds
Companies, on the other hand, can issue secured bonds (or notes), meaning the bond is backed by collateral: real estate (mortgage bonds), financial assets (collateral trust bonds), and heavy mobile equipment (equipment trust certificates).
Or, in the US market, unsecured bonds (backed by the company's credit) are called debentures. These debentures have different seniority levels for lenders (or investors): senior and junior obligations, each of which can be subdivided into multiple ranking tiers.
Why would you accept higher risk by buying junior debentures instead? The answer is the risk premium: interest will be higher on the former, and some investors are willing to participate in these riskier assets, such as high-yield mutual funds, hedge funds, private funds (equity and credit), and others.
For instance, in the event of a company’s liquidation, the waterfall effect will look something like this (specific priorities vary under different foreign laws):
Secured creditors have a direct lien on their collateral and are paid first from the proceeds of that collateral up to their claim amount.
Administrative expenses of bankruptcy (court fees, trustee expenses, post-petition lawyers and accountants) come next, with statutory priority over general unsecured debts.
Priority unsecured claims (statutorily capped unpaid employee wages and specific government taxes) follow.
Senior unsecured debentures (general unsecured debt) come after priority claims.
Subordinated / junior debentures: their rank will be senior subordinated, subordinated, and junior subordinated.
Equity holders: preferred stock, then common stock at the bottom.
Why Bond Prices Move: The Price-Yield Seesaw
As discussed in previous articles, bonds also have benchmark rates. In the US market, US Treasuries (UST) are the standard. Bond issuances, when pitched to investors, express the interest rate as UST (of the relevant maturity) plus a spread (spread over Treasuries, or SOT), since it’s impossible to foresee where the UST rate will be at issuance. The pricing date (when the bond is issued) sets the coupon rate, and the market will know whether it was below or above the original SOT guidance, which implies it was oversubscribed (more demand than the offering) or undersubscribed (the opposite).
This matters because, regardless of the issuer's financial performance, the bond's price can change if the benchmark rate (UST) moves higher or lower. On top of that, the issuer's credit quality can change over the life of the bond, adding another layer to the equation. So, if rates rise, the bond's price falls; if they fall, it rises. This is called the Price-Yield Seesaw effect. Price action happens constantly, especially in the most liquid assets, where heavy trading occurs daily.
Because of this price action, financial assets must be valued to market, called mark-to-market (M2M), which is done daily and, on trading floors, multiple times a day. This shows how much the financial asset has gained or lost (Profit or Loss, or P&L), or unrealized P&L. The P&L becomes realized when the bond is sold.
Example 2: Suppose you buy a 5-year Treasury note issued at par ($100) paying a 5% coupon (semi-annual payments of $2.50). If prevailing market interest rates rise to 6%, no investor will pay you $100 for a 5% stream when newly issued notes pay 6%. To make your bond attractive, its market price must drop to approximately $95.73 (a loss of 4.27%). Conversely, if market rates drop to 4%, your 5% coupon is more valuable, and its price rises to roughly $104.49 (a gain of 4.49%).
The longer the tenor (or the further away the maturity date is), the greater the impact a rate move will have on the bond’s price. The shorter the tenor, the smaller the impact. The industry calls this duration.
Example 3: To illustrate duration, let’s use the same figures as our previous example. If it were a 30-year bond instead of a 5-year note, a 1% rate hike to 6% would drop its price to $86.16 (a loss of nearly 14%). If rates dropped to 4%, its price would jump to $117.38 (a gain of over 17%). The coupon and credit quality are identical, but because those cash flows are locked in for three decades, the price swing is more than three times larger. Compare these numbers to Example 2’s.
If you own an individual bond and hold it to maturity, interim price swings don’t change your outcome; you receive your principal back at par. But what happens if you invest through an open-ended bond fund instead? Unlike individual bonds, bond funds never mature; they are perpetual portfolios. Investors can redeem shares daily, regardless of the underlying portfolio’s remaining maturity. If interest rates spike and redemptions rise, the fund manager may be forced to sell bonds at depressed market prices, locking in permanent capital losses.
This is where M2M comes in, and why these funds' values vary. They have to M2M their portfolio daily to price the fund; regardless of how frequent redemptions are, they may also have to sell securities to honor them.
Conclusion
After all this conversation, do you feel like the person in the picture?
You’re not alone; you will be surprised how many people have little to no understanding of an asset class at the bottom of the sophistication pyramid of financial assets. If you now understand that “fixed income” does not mean “fixed price,” you are already ahead of most investors.
I also hope this note has opened your eyes to how many layers of complexity an asset class considered “simple” can have. Not to frighten you, but to make you aware.
When you make decisions with your hard-earned money, they should be based on neither gut feelings nor emotion. Every decision carries risk, and you are the first line of defense for yourself and your money. A calculated risk, whether it goes in your favor or not, is fine. And by “calculating it,” you probably invested just a small portion of your assets with an informed decision. Taking an uncalculated gamble, even if it pays off, is mere luck.
Read the article again. Nowadays, we spend hours scrolling videos on social media, but limit our reading time. I’m quite sure that if you read it again, you will get a better grasp. Take your time; these concepts require patience, and they are foundational.
For readers with more experience in financial markets, I know there's plenty more to cover about this asset class, and I hope we'll do it in time. For now, this should suffice.
Now that we know how an individual bond is priced and why its value moves over time, what happens when we plot these yields across all maturities, from 1-month bills to 30-year debt? That creates the yield curve, the subject of our next article.
For financial decisions, consult a licensed advisor in your country of residence.
Best,
