After our November newsletter and latest blog, many of you asked what bonds were and why we were paying so much attention to the bond market.
What is a bond?
Simply stated, a bond is a loan made by an investor to a borrower (typically a corporation or government) where the investor receives regular interest payments from the borrower. Bonds have a maturity date at which point the loan amount must be paid back in full.
Governments use bonds, known as Treasury Bills, to borrow money for funding of schools, infrastructure, etc. Corporations use bonds to grow their business, purchase property, etc.
The benefit of bond markets is that they typically offer lower interest rates than banks, so for governments or corporations it makes more financial sense.
What is a Treasury Bond?
Let's focus on the U.S. government bond market. U.S. Treasuries are supposed to be risk-free government-issued securities, as they are backed by the full faith and credit of the U.S. government. They should not be volatile and are considered a "safe haven" asset.
The bonds are issued at monthly online auctions held directly by the U.S. Treasury. A bond's price and yield are determined during the auction. After the auction, bonds are trading actively in the secondary market and can be purchased through a bank or broker.
There are four types of Treasuries:
Treasury Bills (T-Bills)
T-Bills have short durations of one year or less.
Treasury Notes (T-Notes)
T-Notes have medium durations between 2 and 10 years.
Treasury Bonds (T-Bonds)
T-Bonds have long durations, issued with maturities between 20 and 30 years.
Treasury Inflation-Protected Securities (TIPS)
TIPS are indexed to inflation in order to protect investors from a decline in purchasing power of their money. As inflation rises, TIPS adjust in price to maintain its real value. TIPS are offered in several durations - 5, 10 or 30 years.
The interest the government pays on these bonds is also known as the yield for these Treasury bonds. These yields influence the interest rates that individuals and businesses pay to borrow money.
Let's further understand how the yield is determined. During the auction, if the demand is high, the bond yield lowers. If the demand is low, the bond yield increases. Each of the Treasury securities have a different yield, with longer dated ones having higher yields.
Why are we paying attention to the bond markets?
Treasury yields also let investors know how to feel about the economy. Higher yields on long term Treasuries indicate more confidence in the economic outlook.
The Treasury yield curve draws out a line chart to demonstrate a relationship between yields and the different Treasury securities. Here is a normal curve vs a flat curve vs an inverted curve:
Treasuries on a normal curve have higher yield. A flat curve has relatively close yields across the board and may indicate the economic outlook is becoming worrisome. An inverted curve has short dated Treasuries with a higher yield and is usually a pre-cursor to a recession.
The bond market is seen as a leading indicator as inversions have a good track record of forecasting a recession. The bond market tends to receive significant attention once the curve starts to flatten.
Below is the current yield curve with the curves from the past two years:
Right now, curves look normal and nothing to panic over.
Along with watching the yield curve, we also watch the volatility in the bond markets. Overall, the bond market should be rather stable. Below is the bond volatility index going back to 2006:
The major upticks in volatility were in 2008 during the global financial crisis and last year during the pandemic.
Below shows the S&P 500 in comparison to the bond volatility index over that same time period. The bond market actually tends to show signs of volatility before it ever hits the equities:
What we are seeing in the past year, is rising volatility in the bond market. You can see the steady incline in the index. To us, this is something we need to keep our eyes on.
Now you know what a bond is and what to look for in the bond market. If you have any more questions, let us know in the comments.
Thank you for reading!
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Disclosures
I am not a licensed financial advisor or financial professional. This is not investing advice. I am simply sharing my research and opinion based on that research. It is very important that you do your own research and make investments based on your own personal circumstances, preferences, goals and risk tolerance.
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