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.
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.
A place to buy & sell bonds
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" 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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A bond represents a loan made to a corporation or government in exchange for regular interest payments. The bond issuer agrees to pay back the loan by a specific date. Bonds can be traded on the secondary market.
Income you can receive by investing in bonds or cash investments. The investment's interest rate is specified when it's issued.
The profit you get from investing money. Over time, this profit is based mainly on the amount of risk associated with the investment. So, for example, less-risky investments like certificates of deposit (CDs) or savings accounts generally earn a low rate of return, and higher-risk investments like stocks generally earn a higher rate of return.
Usually refers to common stock, which is an investment that represents part ownership in a corporation. Each share of stock is a proportional stake in the corporation's assets and profits.
The amount that the holder of a bond will be paid by the issuer at maturity, which can differ from the bond's value on the open market.
The income on an investment, expressed as a percentage of the investment's value.
A general rise in the prices of goods and services.
The length of time between a bond's issue date and when its face value will be repaid.
A marketplace in which investments are traded. The exchange ensures fair and orderly trading and publishes price information for securities trading on that exchange.
A type of investment that pools shareholder money and invests it in a variety of securities. Each investor owns shares of the fund and can buy or sell these shares at any time. Mutual funds are typically more diversified, low-cost, and convenient than investing in individual securities, and they're professionally managed.
A type of investment with characteristics of both mutual funds and individual stocks. ETFs are professionally managed and typically diversified, like mutual funds, but they can be bought and sold at any point during the trading day using straightforward or sophisticated strategies.
Liz Tammaro: So Ron, I'm going to start with a question from John in Oregon. John is asking, "Can you please explain the relationship between interest rate changes and the NAV of bond mutual funds?"
Ron Reardon: That's a good question, Liz. And actually a great one to start off with because it's a very key concept for investors in fixed income funds or bond funds. There's an inverse relationship between the two. So as yields decline, bond prices will increase, and vice versa, as yields increase, bond prices will fall
Liz Tammaro: Okay and so actually while we are talking about some of the basics here we're going to go to a second question, which is, since bond prices decrease as rates rise, which we've established, why would anyone be buying bonds in the anticipation of a Fed rate increase? Chuck, you're a financial advisor, what do you think about that question?
Chuck Riley: Right, that's a good question that a lot of investors have been asking over the last several years; it's kind of the $1 million question. Investing you're supposed to be making money, why would I be investing in something that seems like it's poised to go down in value. And what I've been reminding investors a lot about is the fact that the reason that you hold bonds in a portfolio, and really the whole reason, primary reason for holding bonds in your portfolio is that they provide the protection in your portfolio from the volatility of stocks. And if you look at the two there's no comparison in terms of the volatility, even in anticipation that rates are going to rise and bond values are going to fall. They're nothing like stocks.
There's a chart that we have that I use with clients called a bear market chart that compares the bear markets of the bond market versus the stocks. And you can see, if you look at just the difference on that chart on the left how much deeper, how much further stock prices fall relative to bonds. And that stocks have a much more greater potential of decline. And so even though bonds are going to potentially go down in value over the next couple of years, the share prices are—the amount that they go down is just so much less.
And so having that protection in the portfolio is key. You are getting some interest income to help out with the portfolio overall return, that's really the primary purpose, that income is just to help out with return. Because what's the only other option to provide stability in the portfolio is cash and we all know what cash has been paying, it's literally almost nothing these days.
So that's why you hold bonds in a portfolio. If your portfolio's a little light on bonds, if your allocation's a little light, you should be buying bonds. Sounds strange but that's really a very good way to maintain your portfolio and to invest sensibly.
Liz Tammaro: Yes, so what I'm hearing you say is that bonds actually serve a balance to stocks in a portfolio in terms of risk and volatility.
Chuck Riley: That's correct.
All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss.
Investments in bonds are subject to interest rate, credit, and inflation risk.
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