Portfolio Management
The markets & your portfolio
Financial markets
Stock market
Stock exchanges
Bond markets
The markets & your portfolio
Portfolio Management
The markets & your portfolio
Financial markets Stock market Stock exchanges Bond markets
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
To understand how the bond markets work, remember that abondessentially represents an IOU—a promise to repay a loan on a certain date, along with specifiedinterestpayments along the way.
Prices and interest rates for anindividualbond 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,returnsin 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 ofstocksissued 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 theface valuewhen 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)yieldsdown.
Also, when expectations for futureinflationare extremely low, this can cause a scenario in the bond markets known as an "inverted yield curve."
Normally, bonds with longermaturitieshave to offer higher interest rates to entice investors into tying up their money for a long time.
When the yield curve is inverted, bonds withshorterdurations 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 centralizedexchangefor 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 throughmutual fundsorETFs (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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