Bonds Basics Sept 10

Bonds are simply a type of security that is issued to borrow money from investors. Bonds can be issued by governments or corporations. Governments worldwide issue bonds to borrow money to make up for shortfalls in revenue, finance large-scale projects or as a means to offset other areas of government debt. Corporations issue bonds to raise the money they need to sustain current operations or to expand their capabilities and fund new projects or acquisitions.

Bonds are comprised of the principal owed and the interest to be paid. Bonds can range in maturities from a month to many decades. Generally, treasury bills refer to maturities less than one year and notes refer to maturities from one to 10 years. However, whatever the maturity, this form of corporate or government debt is correctly referred to as a bond.

When an investor purchases a bond the buyer is entitled to receive the principle of the bond upon maturity and periodic interest payments typically in the form of regular coupons while the bonds are being held. Coupons, or interest, are paid at varying intervals which are established upon the issuance of the bond. The terms of some bonds provide that they may be called prior to their maturity date. This allows the issuer to pay the principal and thereby cease making interest payments. These are important provisions to consider when purchasing any bond as the relatively advantageous interest-rate the buyer is receiving upon purchase is subject to being terminated when the bond is called.

The concept of buying bonds is predicated upon the principle of total return. Total return includes the overall value of the coupon interest as well as price movements in the price of the bonds themselves. For most individuals, the idea of buying bonds is simply to hold a bond to maturity and collect the interest coupons. However, buying bonds earning interest and selling them as yields fall and prices increase is the method bond traders use to invest in bonds as an asset class and profit from their total return and price movements.

The key concept to remember regarding bonds is that their price moves inversely to their yield. Meaning as the price of the existing bond increases the yield on the bond decreases. And conversely, as the yield on the bond increases the price of the bond decreases. This is a very important and often confusing aspect of bonds to the inexperienced bond trader. It is this inverse correlation that provides the opportunity to profit from the total return of bonds and it is this price to yield correlation that provides insight into the economy, the stock market and the bond market as a barometer of economic conditions.

Many scholars and investors will argue that the bond market is the best indicator of the health of the economy. Others argue that the bond market is too easily manipulated and susceptible to emotions, political influence and market vagaries. I believe, as with most aspects of investing and their theoretical applications, the truth lies somewhere in the middle.

The bond market, similar to the stock market, is a voting mechanism by which investors reflect their fears, hopes and opinions with their pocketbooks. The major difference, however, is that when it comes to the government-backed Treasury market there exist a central bank called the Federal Reserve that is responsible for maintaining growth in the economy while simultaneously limiting inflation. The way they attempt to accomplish this is by controlling the amount of liquidity (money) that is available in the system (referred to as M1-M2) and adjusting the Fed funds rate. That is the rate that the Fed and other banks charge to borrow very short term (overnight) funds usually to meet their reserve requirements. This very short-term rate is the only rate that the Federal Reserve can directly establish or control. However, as a result of changes in the Fed funds rate, the rest of the yield curve is greatly influenced although rates are ultimately controlled and set by the bond market itself.

The yield curve is simply the interest rate of the various bonds when plotted between the longest Treasury bond offered of 30 years and the shortest Treasury bond offered usually calculated at 30 days. A normal yield curve would show the highest interest rates being paid on the longest term bond. An inverted yield curve means that shorter-term bonds are paying higher yields than their longer-term counterparts. In the last several years, the 10-year bond has been used as the benchmark long-term bond.

Many market observers believe that an inverted yield curve is an indication of a faltering or troubled economy. Some economists theorize that it is actually a precursor to a recession. However, over the years, there have been occasions when the yield curve has inverted and no recession has occurred. This inconsistency has made the inversion of the yield curve a questionable indicator at best.

So given this background and understanding what is it the bond market can tell us? More specifically, what is it the bond market is saying about the economy? The answer to that is summed up in one concept: Risk. The Treasury market, considered the safest of all possible investments as it is backed by the full faith and credit of the United States, is perceived and priced as a measure of risk. Theoretically, all classes of investment assets are priced relative to their risks when measured against the safety of Treasuries. For example, the yields on even the highest AAA grade corporate bonds are higher than that of similar maturities in Treasuries because of the higher possibility of default, i.e. risk.

In a similar manner, the risk to Treasuries or any fixed income investment is inflation. Inflation erodes the buying power of the dollar. So while Treasuries offer the safety of the return of principal they carry the risk of depleted purchasing value as they are denominated in dollars and the nominal value of the dollar is impacted by inflation.

As a result, we have the Treasury bond market conflicted by the risk of inflation as it measures and prices in the risks associated with the economy and the value of other asset classes. Now add in global currencies, the impact of the foreign markets and central banks, the growing global economy, a credit and financial crisis, the threat of exogenous events and a myriad of other factors contributing to the ongoing economic uncertainty and the job of the Fed, the investor and the bond market seems insurmountable.

However, while the bond market is subject to the same ephemeral mispricing and dislocations of any financial market or asset class, I believe it does an amazingly consistent (if not perfectly timed) job of pricing in risks relative to prevailing financial conditions in the economy. Similarly, though far from as accurately, the bond market often acts as an early warning system in forecasting changes and future economic concerns as well as predicting the twist and turns inherent in the business cycle.

For example, we have witnessed a financial crisis in the credit markets resulting from sub prime mortgage abuses and the increasing likelihood of mortgage and Collateralized Mortgage Obligation (CMO) defaults, the bond market signaled its concern regarding the increased risk in the credit markets by rising in price and falling in yields.

This bond market reaction had a dual effect. First, it demonstrated a lack of investor confidence and the increased uncertainty regarding the economy as a “flight to quality” in Treasuries ensued. Second, as the 10 year bond fell below 4% it signaled to the Fed the need for more liquidity in the markets beyond mere liquidity infusions and the need to loosen monetary policy via a reduction in the Fed funds rate. In effect, the market had factored in the historic rate cuts for the Fed as a result of falling bond yields.