Monday, June 07, 2004

The bond market and you

Bonds are complicated.

The mention of the word bonds is enough to send most people to sleep. Why?

Most people hate thinking about matters (especially complex ones) that don't have a direct impact on their everyday lives.

Unfortunately, they do.

If I say the word mortgage you might sit up and take an interest (no pun intended).

Understanding the bond market will make you more aware of the risks facing you as a potential (or present) mortgage-holder.


The biggest obstacle most people face when trying to figure out the bond market is the concept of price and yield.

Yields and interest rates are very closely related:

Interest rates are the price of loans;
Yields are the returns paid to bondholders.

Banks lend to their customers;
Bondholders buy the debt of an institution.

Interest rates in banks rise and fall;
Yields on bonds rise and fall.

The biggest concern for mortgage holders is the interest they are paying each month;
The biggest concern for bondholders is the return they are receiving each quarter, year etc.

The bond market is a market for debt. This debt carries with it a price.
The mortgage market is a market for debt. This debt also carries with it a price.

As a mortgage holder you are subject to the ups and downs of interest rates. Higher interest rates means a bigger bill at the end of the month. Similarly, for bondholders, a higher yield means a higher return on their investment.

The bond market is the best (and probably only) way to predict the next move in interest rates. Why?

Bondholders want to eliminate risk from their investment. If they are government bondholders (where rerturn on the initial investment is fixed) they are sensitive to just one risk: inflation.

Inflation purges the value of any investment. Bonds are particularly vulnerable to higher inflation because the rate of return on the initial investment is fixed.

So how does the bond market help predict interest rates?

Since bondholders are extremely sensitive to inflation, even the slightest hint of rising prices will send bondholders running for the hills.

When bondholders get nervous and start to sell, bond prices fall. Since the interest rate on bonds are fixed, the investor buying this bond will enjoy a higher yield.

The yield on bonds is so important, not least since it helps set mortgage rates. Why?

The bond market is huge. The US bond market is almost 1.5 times the size of the country's GDP. The global bond market is 95% the size of world GDP! This makes the bond market important and credible. People are seriously putting their money where their mouths are. If investors who are responsible for this much money flag concerns over future inflation, the government is forced to sit up and take notice. Banks take even more notice.

In the past 10-15 years, central banks and governments around the world have made it their sole mandate to target (or at least very closely watch) the inflation rate. Should the inflation rate exceed a certain target level or get out of control, there was a strong probability that interest rates would rise.


People wise to the bond market will be even wiser to the mortgage market since they will be the first to anticipate higher rates in the future and can take steps to avoid being hurt in the process.

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