Even though we focus on the equities market, it’s just as important to pay attention to the bond market. It is multiples larger than the stock market, and it provides us with key information about the economy. Consider this brief intro your bond market 101 class.
Bond market 101
It’s easy to ignore the bond market. It does not get the attention or headlines that stocks do, because bonds are considered boring. This is true. They are boring. And that is what fixed income investors want: zero excitement and steady returns.
Companies and institutions that issue debt in the form of bonds are obligated to return capital and interest to bondholders before distributing earnings to shareholders. This is why bonds are less risky than stocks.
Bonds mature at different times, from the Fed Funds overnight rate all the way out to 30 years. Normally, the longer the timeline, the higher the interest rate on the loan (not always the case). You can find this information charted out on the yield curve.
Bond prices move inversely to interest rates. A bond at 100 (we call that par) with a rate of 4% for five years is comparable to what can be bought in the open market at that point in time.
If rates rise, the price of the bond goes down, because a comparable rate would be higher in the marketplace. Why would I buy a bond that offers 4% interest if the market is paying 4.25%? Instead, I should pay less for the bond if I’ll be compensated at higher market rates.
Bonds, inflation, and the economy
Maybe the most important thing to know about bonds is that bond investors hate inflation. If interest rates rise due to inflation, a bond investment becomes worth far less than what was initiated. The bond market is the most paranoid about inflation – way more than the equities market. As the saying goes, the bond market has predicted seven of the last two recessions!
When bond yields rise, interest rates for credit cards, mortgages, business loans, etc. also increases. Companies invest less, and consumers spend less, which can slow down the economy.
Even if you do not carry bonds in your portfolio, pay attention to movements in the bond market. It can tell you a lot about the overall health of the economy.
