Bonds, the bond market, bond yields, and the yield curve are important aspects of financial markets that every trader should understand. It doesn’t matter if you are a bond trader or not, understanding the nature of the bond market can provide a deeper understanding of almost any other market on the planet.
A bond, also called a bond, is a guarantee or promise of an individual or legal entity to pay off a debt that can be bought and sold by the public. In fact, this is a way to guarantee debt: the seller borrows money, and the buyer lends. Bonds can be issued by almost any type of organization, but most often they are used by governments and enterprises to attract large amounts of capital. In addition, the bond issuer agrees to pay the bondholder an interest amount, predetermined at the time of issue, as a loan fee.
Governments and enterprises often have to borrow more money than can be obtained through traditional banking funds. To raise this money, they use public bond markets to connect to a larger pool of liquidity. Investors buy bonds in exchange for interest payments that they receive overtime or upon expiration. The amount of interest paid by the issuer and received by the owner depends on a number of factors, including credit rating, interest rates, and demand.
Bond credit ratings are similar to the credit score you receive as an individual and measure the ability of a bond issuer to repay a debt. Ratings are awarded by agencies such as Moody’s and Standard & Poors, ranging from investment grade to unwanted.
Investment-grade bonds have the least likelihood of default, least risk, while unwanted bonds have the highest risk. A higher default risk means a higher interest rate for the borrower, the issuer of the bond. This is good for bondholders because it means a higher rate of return.
Investors seeking security can accept lower returns for guaranteed investments and focus only on investment-grade bonds.
Demand can affect the bond’s price/earnings ratio in the same way as any trading asset. Since bonds are usually issued in batches, the amount of debt available for purchase by investors is limited. If there is sufficient demand, this can lead to higher costs of ownership and lower effective returns. This is bad for an investor in bonds, but good for an issuer, because the cost of borrowing is reduced.
The policy of the central bank determines the terms of trade in bonds
Interest rates are important for bonds because they determine the value for issuers and the yield for investors. What makes it difficult to trade bonds is that interest rates change over time, which means that sometimes you want to be a seller of bonds, and sometimes a buyer of bonds.
The main force behind this is the basic or basic rate supported by the central bank of the country in which the bonds are issued. When the base rate is high, bond rates tend to be higher, and when the base rate is lower, bond rates tend to be lower. The problem for bond traders is to track the process of changing monetary policy and the main rate.
Central banks are moving their goals at the basic rate up and down, trying to maintain economic stability in their countries. If economic activity is too high, they increase the cost of borrowing money so that it is more difficult for businesses to take loans. If the activity is too low, they lower the rate to stimulate business investment and movement in capital markets. Experienced investors can sell bonds briefly when rates are low, and then redeem them, making high profits from changes in the value of bonds, while at the same time receiving interest payments.
Inflation is the main reason for the chance in monetary policy
The number one tool that central banks use to measure the state of the economy and determine the path of their policies, whether raising or lowering rates, is inflation. Inflation is a measure of price increases over time and can be applied to many aspects of the economy. The two most commonly tracked indicators are business and consumer inflation. The two most tracked inflation reports are regularly published – the Producer Price Index (ProducerPriceIndex) and the Consumer Price Index (ConsumerPriceIndex).
Of these, the consumer price index or CPI is the most important. Consumers are the foundation of the modern economy. If producer prices can fall to consumer prices or consumer prices become too high, the economy will crash. In the US, the Consumer Price Index or PCE is the preferred tool for measuring inflation at the consumer level. It is published once a month and is part of the quarterly GDP report.
Most central banks prefer a target inflation rate of 2.0%. This means that when inflation is below 2.0%, central banks tend to “adapt” to their economies and weaken their policies by lowering interest rates. When CPI or PCE is above 2.0%, central banks tighten their policies by raising interest rates.
Labor market data and their role in the inflation picture
Labor data plays an important role in the inflation picture. First of all, no economy can function if its people do not work. FOMC is endowed with two functions, and one of them is to ensure maximum employment. In this light, indicators such as off-farm wages, unemployment, and average hourly earnings are becoming important. The difficulty that the FOMC faces is that stimulating labor markets can lead to higher wage inflation.
Economic activity, central banks and bond trading
Economic activity is the alpha and omega of bond trading. When economic conditions are good, capital markets are overwhelmed, when economic conditions worsen, capital markets are depleted, and bonds are more difficult to issue. The conclusion is that central banks try to manipulate economic conditions and do so with the help of interest rates. When conditions are bad, interest rates will fall, when conditions improve, interest rates will rise until they reach the point at which the economy will stop developing. This is the nature of the bond market and bond trading. It is important to understand that the ebbs and flows are the keys to success in bond trading.
When the economy works poorly and the stock markets are very volatile, investors tend to switch investments to fixed income securities, which increases activity in the bond market. But it is not always the case. High volatility can sometimes push investors to short-term trading through online platforms. In this way, they can benefit from both sides of the market without having to hold stocks for a long time.
Profitability curve and market prospects
There is an unlimited supply of bonds, but not all are the same. The safest, most trusted and closely watched are US Treasuries. US Treasury bonds are issued with different maturities from a few weeks to thirty years. The yield for each maturity varies depending on the demand for time frames, long-term or short-term investments, and can be analyzed to understand market sentiment.
Known as the yield curve, in good times the yield spread increases as you move. This is due to the fact that investors believe that interest rates will be higher in the future, so they do not want to fix low returns for too long. This phenomenon leads to a higher demand for shorter maturity bonds and a “normal” yield curve. In bad times, everything changes. Investors in bonds believe that interest rates will be lower in the future, so they seek to consolidate a higher rate for a longer period. This creates a higher demand for bonds with longer maturity and a signal known as the inverse of the yield curve.