Points to know
- As interest rates change, the values of bonds will fluctuate.
- The bond markets are affected more by the interest rate environment than anything else.
- Bonds are traded over the counter, not on exchanges.
Investing strategies
Bond markets
Bond markets tend not to see big swings in value like stock markets do. But they do fluctuate, thanks mostly to changes in interest rates.
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A place to buy & sell bonds
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.
Why do interest rate changes move bond prices?
Imagine you loan your friend Jen $1,000. She agrees to pay you back in 1 year. She'll also give you monthly interest payments at a 5% interest rate. (So you'll earn $50 during the year.)
Then your friend Tom starts offering $1,000 loans at a 4% interest rate. You feel pretty good, because your loan is making you more money than what Tom'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.
What else can shake up bond markets?
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.
Where & 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 symbol" to show you trades in real time.
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, there are many bond indexes that measure different types of bonds, but unlike with 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.
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All investing is subject to risk, including the possible loss of the money you invest.
Bonds and bond funds are subject to the risk that an issuer will fail to make payments on time and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments. Investments in bonds are subject to interest rate, credit, and inflation risk.