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Booyah Breakdown: Bonding With Bonds, 2

Tracy Byrnes

Editor's Note: This is the second of a three-part Booyah Breakdown series on bonds.

Welcome back to the Booyah Breakdown's bond school.

We started our matriculation last week by defining some bond basics: face value, interest rate, yield, etc.

Today, we're going to discuss how bonds and their interest rates change in the marketplace.

And next week, our graduation lesson will be a scrutiny of the infamous inverted yield curve, which all the pundits are talking about these days.

So pour yourself a cup of coffee and let's bond (sorry, couldn't resist).

Start at the Treasury

"Everything revolves around the government bond market," says Mark Mesinger, VP of Fixed Income Trading at Charles Schwab (SCHW). The whole world relies on the U.S. Treasury market as a basis for spreading other debt."

So let's understand the Treasury market. The U.S. government has trillions of dollars in outstanding debt that has to be paid back. Uncle Sam sells Treasury bonds, notes or bills to raise some money to pay back this debt to other countries.

In the past, Treasuries were mostly purchased here at home by all the big investment banking firms, which ended up controlling the supply and demand.

But these days, the global market has control. With our interest rates creeping up (can't forget those 17 interest rate hikes) over the last few years, its no surprise, the rest of the world wants to play here.

"The U.S. is seen as a safe haven so the world looks to our Treasury market as a safe place to invest," says Mesinger. Now the predominant buyers of our Treasuries are the central banks of overseas powerhouses like Japan, China and Europe.

The demand for our Treasury market is twofold. First, we still have some of the highest interest rates in the world. Second, the U.S. dollar is cheap in other nations. (See this previous column for more on how the dollar is valued overseas.)

As an example, let's fly to France (can we, please?). Since the dollar is so cheap, Parisians can sell their euros over here and get more dollars. Let's just assume they have 1,000 euros. They'll end up with about $1,349. They can then take that $1,349 and invest it in our treasury market and, in turn, they've made a fair amount of very safe money.

Since lots of overseas investors are making that safe investment these days, the interest rates stay strong and demand remains up.

Once the interest rate on Treasuries is established, it can be used as a proxy for every other bond out there, says Mesinger.

Other Bond Players

Now let's talk about investment-grade corporate and high-yield bonds.

Investment-grade corporate bonds are issued by fundamentally strong companies for the same reasons the government offers Treasuries. Companies need capital for projects, expansion, etc., so they offer bonds in an attempt to raise some money.

Corporate bonds are graded by special rating agencies such as Standard & Poor's or Moody's Investors Service. A triple-A rating is the highest grade a company can get. That means, as a bond investor, you can sleep well knowing the company has the money and the integrity to pay you back, with interest, when your bond matures.

As a company's flawlessness disappears, so does its rating. The second-highest rating is a double-A, then single-A, followed by a triple-B, a double-B and so on.

But even a solid company with a high rating offers a better yield, or interest rate, than Treasuries. That's because you take on a bit more risk by lending your money to a company than you do with Uncle Sam. So you need to be compensated for that extra risk, hence the higher interest rate, or yield.

You can take an even riskier path and invest in high-yield bonds. Those bonds are issued by companies that have ratings below triple-B. That means the company's financial situation is a mess and the probability that it's going to default on your bond is high.

But, of course, there's always the chance the company will come through for you. So to entice you into taking that gamble, these companies offer a really high yield.

Of course there are other types of bonds -- foreign bonds, mortgage bonds, etc. -- but that's fodder for another day.

Establishing a Bond's Price

Now remember, a bond's face value is usually either $1,000 or $5,000, but you don't necessarily have to pay that upfront. Bond prices fluctuate. And the market's perception of the bond and its issuer is one of the biggest reasons for that volatility.

Let's take, for example, a bond with a $1,000 face value. If other investors don't think the company issuing the bond will be able to meet its obligations, or if the company suffers a blow to its reputation, the price of the bond will decrease in value, say to $800. The opposite is true if the company is a Wall Street darling. Then the bond's price will increase, maybe up to $1,200. So that's what you'll have to pay to buy the bond.

The company's stock price is a good litmus for the bond price because you can see how it's being perceived in the market. If it is disliked or there's unfavorable news about the company that's affecting the stock, that negativity will spill over and be reflected in the bond price as well.

Like their prices, bonds' yields are also in constant flux, mainly because they play off each other. Back to basic economics: When a bond's price rises, its yield drops. When its price falls, its yield rises.

So when a bond's price drops, you don't have to pay as much upfront and you get a better interest rate. You win.

Conversely, if a bond's price increases, you pay more upfront and get a lower yield.

But the connection between a bond's price and its yield can get even deeper and many will argue that the relationship between the two can be used to foretell the market.

Enter that infamous yield curve, which we'll, uh, bond with next week.

1 What would best describe your stance heading into the coming week of trading? Bullish Bearish Neutral 2 Which of these sectors do you think is set to move up in the coming week? --Choose One--Aerospace and DefenseAirlinesAutomobilesBeverages and Food ProductsBiotechnologyCommercial BanksComputers and PeripheralsConsumer NondurablesEnergy Equipment & ServicesHMOs and HospitalsHomebuildingInsuranceIntegrated OilInternet, Software ServicesInvestment Bankers and BrokersMediaMultiline RetailPharmaceuticalsPrecious MetalsSemis, Semi EquipmentTelecom EquipmentTobacco and AlcoholWireless CommunicationsUtilities 3 Which of these sectors do you think is set to move down in the coming week? --Choose One--Aerospace and DefenseAirlinesAutomobilesBeverages and Food ProductsBiotechnologyCommercial BanksComputers and PeripheralsConsumer NondurablesEnergy Equipment & ServicesHMOs and HospitalsHomebuildingInsuranceIntegrated OilInternet, Software ServicesInvestment Bankers and BrokersMediaMultiline RetailPharmaceuticalsPrecious MetalsSemis, Semi EquipmentTelecom EquipmentTobacco and AlcoholWireless CommunicationsUtilities View the results without voting