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Analytics, 23 July 2021

Understanding Bond Markets: How they work

From the outbreak of the pandemic in early 2020, and more recently amid rising inflation, the bond market has captured the attention of investors. Analysts have developed a fascination for interpreting movements in the Treasury Bond market as a sentiment indicator and a forecasting tool, for everything from stock market prospects to recession probabilities or inflation threats, and even changes in Federal Reserve monetary policy.

In the past few weeks, the bond market has defied Wall Street forecasters, as long-term Treasury yields kept heading lower despite a strong economy and rising inflation. A decline in bond yields, which move opposite prices, can be a sign of expectations for a weaker economy.

What is the Bond Market?

The bond market is a place to buy and sell bonds. Often called the debt market, fixed-income market, or credit market— the bond market is the collective name given to all trades and issues of debt securities.

What are bonds?

Simply defined, bonds are units of corporate debt issued by companies and securitized as tradeable assets. A bond is a fixed income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). Bonds are used by companies, municipalities, states, and sovereign governments to finance projects and operations. Owners of bonds are debtholders, or creditors, of the issuer.

Bond details include the end date when the principal of the loan is due to be paid to the bond owner and usually include the terms for variable or fixed interest payments made by the borrower.

Types of bonds

How does the bond market work?

To understand how the bond markets work, remember that a bond essentially represents an IOU—a promise to repay a loan on a certain date, along with specified interest payments along the way.

Prices and interest rates for an individual bond depend on a variety of factors, including positive or negative news about the issuer or changes in its credit rating.

But at a higher level, returns in the bond markets are much more related to interest rate changes—and perceptions about what will happen to interest rates in the future.

How are bonds traded?

Bond traders specialize in a certain type of bond—Treasuries, municipal bonds, or corporate bonds. Unlike with the stock market, there’s no centralized exchange for bonds. All trading is done between individuals, so there’s no giant “bond ticker” to show you trades in real-time.

Most bonds can be sold by the initial bondholder to other investors after they have been issued. In other words, a bond investor does not have to hold a bond through to its maturity date. It is also common for bonds to be repurchased by the borrower if interest rates decline, or if the borrower’s credit has improved, and it can reissue new bonds at a lower cost.

Because of the lack of transparency with bonds as compared with stocks, many or most investors could be better off if they invest in bonds through mutual funds or ETFs (exchange-traded funds) rather than by buying individual bonds.

As with stocks, many bond indexes measure different types of bonds, but unlike stocks, they’re not widely reported in the general media. The benchmark number you’re most likely to see is the current yield of the 10-year Treasury.

Why interest rate changes as bond prices move

Imagine you loan your friend Andrew $1,000. He agrees to pay you back in 1 year. He’ll also give you monthly interest payments at a 5% interest rate. (So you’ll earn $50 during the year.)

Then your friend John starts offering $1,000 loans at a 4% interest rate. You feel pretty good because your loan is making you more money than what John’s getting.

In fact, your loan is so attractive in comparison that if you want to sell it to someone—give them the rights to collect the interest payments and the $1,000 at the end of the year—you can actually charge a premium.

As you can see, when interest rates fall, the prices of existing bonds go up. And when interest rates rise, the opposite happens: If your loan is earning you less money than someone could make by giving a brand-new loan, they’re going to pay less to buy your loan.

Why are bond markets more stable than stock markets?

You may be wondering why the values of stocks issued by certain companies will fluctuate much more than bonds issued by the same companies. When companies issue bonds, they’re contractually obligated to make the specified interest payments as promised and to return the face value when the bond matures.

Defaulting on a bond is serious and will typically force a company into bankruptcy. (Even when a company goes bankrupt, bondholders will be repaid using company assets, if available.) So companies place a high priority on making timely bond payments.

Because the terms of a specific bond are known in advance, the value of that bond will usually fluctuate in a relatively narrow range as compared with stocks.

Other factors that affect the bond market

When investors are running scared from volatility in the stock market, they often move money into bonds. This pushes bond prices up, and (as we learned above) yields down.

Also, when expectations for future inflation are extremely low, this can cause a scenario in the bond markets known as an “inverted yield curve.” Normally, bonds with longer maturities have to offer higher interest rates to entice investors into tying up their money for a long time.

When the yield curve is inverted, bonds with shorter durations have to offer higher interest rates. This is because investors prefer to lock in the current yield for as long as possible, on the assumption that it will be a long time before yields are as good again.

Though not always, bonds sometimes reflect macroeconomic prospects, especially during times of crisis when the trend and the motivation to move into haven assets is so obvious that no confirmation is needed.

When the Covid-19 pandemic hit in March 2020, bond prices rose (and yields fell). It was a classic flight to safety – panic buying of Treasury’s by investors looking to get out of the falling stock market. However, bond yields can be a poor indicator of stock market conditions – apart from moments of severe crisis.

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