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What Is the Bond Market and How Does it Work?

Is the bond market a mystery to you? You're not stupid, and you're not alone.

NEW YORK (TheStreet) -- Bond market a mystery to you? You're not stupid, and you're not alone. The bond market -- which is really several markets: the Treasury bond market, the corporate bond market and the municipal bond market, to name three -- is a tough nut to crack. What with prices and yields moving in opposite directions, basis points and the yield curve, to say nothing of spreads and duration.

Don't despair. Anyone can understand the bond market. Really!

For a basic explanation of what a bond is and how it works, and for definitions of all the terms mentioned above and more, see our financial glossary. Meanwhile, here are answers to frequently asked questions about how the bond market works.

What Moves the Bond Market?

The bond market moves when expectations change about economic growth and inflation. Unlike stocks, whose future earnings are anyone's guess, bonds make fixed payments for a certain period of time. Investors decide how much to pay for a given bond (that is, for a stream of fixed payments of a certain length) based on how much they expect inflation to erode the value of those fixed payments.

The higher their expectations of inflation, the less they will pay for bonds. The lower they expect inflation to be, the more they will pay.

In bondland, lower prices correspond to higher yields, and higher prices correspond to lower yields. When prices fall, yields rise, and vice versa.

The reason is simple: Yield measures the value of a bond to an investor, depending on how much the investor paid for it. The lower the price at which you buy, the better the deal you are getting. The higher the price, the worse the deal. An investor who pays a price of 98 for a bond that pays interest at the rate of 7% (its so-called coupon rate) for 10 years gets a better deal than an investor who pays 100 for the same instrument. The investor who pays 98 gets a yield of 7.25%. The investor who pays 100 gets a yield of 7%.

Are Interest Rates and Yields the Same Thing?

They can be. "Yield" has a very specific meaning, while "interest rate" is used more loosely. A bond's yield is its annualized return, depending on its coupon rate, the time remaining until it matures and the price paid for it.

"Interest rate" is sometimes used to refer to a bond's coupon rate, which is fixed. But "interest rates" can also refer generally to the cost of money, which will differ depending on the borrower and the term of the loan, and which are indicated by bond yields. When bond prices are rising, lowering their yields, interest rates are falling.

Here is the link between the two uses of the term: Yields, which are a function of market prices for existing bonds, determine the coupon rates that borrowers will have to pay on new bonds.

For example, suppose a company issues a 10-year bond with a 7% coupon at a price of 100 to yield 7%. Then, in response to some negative news, the bond's price falls to 98, boosting its yield to 7.25%. At that point, a comparable borrower wishing to sell a 10-year bond at a price of 100 would have to attach a 7.25% coupon, as indicated by the market's assessment of how much a bond of that variety should yield.

Why Do Treasury Prices and Yields Matter?

Because Treasury yields are the most basic of all interest rates. Consider: Any interest rate has two components: one determined by the term of the bond, the other by the creditworthiness of the borrower.

Normally, the component determined by the term of the bond will be larger for a longer-maturity bond than for a shorter-maturity one, reflecting the fact that over a longer period of time inflation can have a larger effect on a bond's fixed payments. A higher interest rate compensates investors for taking that risk.

Meanwhile, the component determined by the creditworthiness of the borrower will be largest for the least creditworthy borrowers. Just as people with bad credit pay higher interest rates, institutional borrowers with low credit ratings pay more than sterling borrowers. A higher interest rate compensates investors for taking the risk that they will not be paid in full and on time.

Treasury yields are the most basic (and the lowest) of all interest rates because for all intents and purposes, there is no creditworthiness component. The U.S. government, which issues Treasury bonds, notes and bills, is considered a safe bet to make all payments in full and on time.

This gives Treasuries benchmark status. In general, all bond yields rise when Treasury yields are rising and fall when Treasury yields are falling. But the Treasury yields are a more-or-less pure reflection of inflation expectations, unencumbered by premiums based on the likelihood of default.

How is the Bond Market Affected by the Stock Market, and Vice Versa?

There are no hard and fast rules here, just guidelines. And the markets don't play by all of the guidelines all of the time. Depending on the circumstances, investors pick and choose.

Guideline 1:

Low interest rates are good for the stock market, and high interest rates are bad for the stock market. So when bond prices rise (yields fall), stock prices should rise too, and when bond prices fall (yields rise), stock prices should also fall.

Low or falling interest rates are good for the stock market for two reasons. First, because low or falling interest rates stimulate economic activity, allowing companies to do more business. Second, because bonds are an alternative investment to stocks. The lower the yields on bonds, the less appealing an alternative they represent. Conversely, high or rising interest rates simultaneously curb economic activity, and make bonds more appealing as an alternative to stocks.

Guideline 2:

Rising stock prices can lead to higher inflation and falling stock prices can lead to lower inflation. So when stock prices rise, bond prices should fall (yields rise), and when stock prices fall, bond prices should rise (yields fall).

The stock market helps drive the economy by influencing consumer confidence. When the stock market is doing well, consumer confidence runs high, and when the stock market falters, so typically does consumer confidence. Consumer confidence is key because spending by consumers (as opposed to spending by companies or the government) is the majority of U.S. economic activity. It follows that if consumers are confident, they will spend freely and the economy will grow. Likewise, if consumers lose confidence, they will become tightfisted and economic growth will slow.

If bond investors think the economy may be growing too quickly, running the risk that inflation will pick up, they'd rather see stock prices go down than up.

Guideline 3:

When stock prices are falling quickly and hard, investors may "park" money in the bond market, causing bond prices to rise.

The predictability of returns from bonds makes prices much less volatile than stock prices. So when investors become concerned with principal-preservation, they reach for bonds. It's not unusual to see Guidelines 2 and 3 in play at the same time. Both call for bond prices to rise when stock prices fall. But bond market professionals may distinguish between demand for bonds stemming from the belief that falling stock prices will slow the economy, and demand for bonds based on panic alone. They call the latter "flight to quality."

Where Does Bond Trading Take Place?

The bond market is an over-the-counter market, meaning that there is no trading floor or other centralized location where trading takes place. Nor is there a computer trading system comparable to the Nasdaq Stock Market. People are developing computer systems for bond trading, but for the most part, bonds are still bought and sold the old-fashioned way: Over the phone.

In the Treasury bond market, interdealer brokers -- firms that broker trades between bond dealers -- disseminate the prices at which trades take place. But because most interdealer trades involve at least $1 million par value, those prices may differ greatly from the prices individual investors pay and receive in smaller transactions.

Where Can I Find Treasury Prices on the Web? How About Charts?

Our ticker quotes the 10-year Treasury note's price and yield. For quotes on the full spectrum of Treasury issues, Bloomberg is the best source. Here is a link to the page: Bloomberg U.S. Treasuries page

Yahoo! Finance offers reasonably good daily and intraday charts of Treasury yields. The quotes are actually based on options listed on the Chicago Board Options Exchange, but they match the Treasury yields. Here are the relevant ticker symbols:

10-year note: ^TNX

30-year bond: ^TYX

Five-year note: ^FVX

Why Are Long-Term Treasury Yields Sometimes Lower Than Short-Term Ones?

This is not normal, but in January 2000, long-term Treasury yields (the 10-year note and 30-year bond yields) plunged below short-term yields (the two- and five-year note yields), and stayed lower until September, when the situation began to reverse.

Normally, investors demand higher yields on long-term bonds than on short-term ones because over a longer period of time, inflation can have a larger impact. Consider: An investor might buy a two-year note at a yield of 6% because he is confident that over the life of the note, inflation, currently running at, say, 2%, will not double to 4%, eroding the value of the note's payments. But the same investor might demand a yield of 7% on a 10-year note, because of the difficulty of forecasting what might happen over a longer period.

Still, the normal relationship between bond yields -- long ones higher than short ones -- embeds the assumption that inflation will stay the same or accelerate.

But if investors believe that the inflation rate will drop, and maybe even turn into deflation, in which prices are falling, they may be willing to buy long-term bonds at lower yields than short-term ones.

Why would anyone be willing to buy a long-term bond at a lower yield than a short-term bond? Based on their expectations. Consider: The buyer of a two-year note will have to reinvest in two years. The buyer of a 30-year bond won't face reinvestment for a generation.

If you believe that the economy is entering a deflationary phase, in which prices will fall because demand is weak, you probably expect that the Fed will aggressively cut short-term interest rates to stimulate economic activity. In that case, short-term bond yields should fall in tandem, once again dropping below long-term yields. Investors in short-term bonds would face the prospect of reinvesting at those new lower rates. If they had bought long-term bonds they would not face that problem.

When long-term yields are lower than short-term yields, bond market participants say the yield curve is inverted.

When the Treasury yield curve inverted in January 2000, it was only partly due to economic expectations, however. It was primarily a supply phenomenon.

In January 2000, the Treasury Department announced a plan to use budget surplus funds to pay down the national debt by buying back Treasury securities from investors at market prices. The buybacks would target the longest-maturity issues, which carry the highest interest rates. The prospect of a shortage of long-maturity Treasuries drove their prices higher, causing their yields to fall below the yields of short-maturity issues. The theory is: If you think that prices of long-term Treasuries -- the 30-year bond in particular -- will continue to go up based on scarcity, then no yield is too low to accept.

The so-called disinversion of the Treasury yield curve that began in September was due in part to changing expectations of future buybacks. Specifically, that the pace of buybacks might slow under the country's new leadership. But it also reflected a shift in thinking on monetary policy. People stopped expecting interest-rate hikes that would slow the economy and started thinking about interest-rate cuts that would stimulate it. At that point, bond investors start demanding long-term yields that are higher than short-term ones.

Why Do Short-, Intermediate- and Long-Term Treasury Yields Sometimes Change by Different Amounts on a Given Day?

Because short- and long-maturity yields have different primary influences. The primary influence on short-maturity yields is monetary policy -- the level of the fed funds rate. Short-term yields rise when the fed funds rate rises (or is expected to rise) and fall when the fed funds rate falls (or is expected to fall). That's because as competing investments, they have to offer comparable interest rates. (You may not face the question of whether to invest in fed funds or short-term Treasuries, but institutional investors do.)

Meanwhile, the yields of longer-term Treasuries mainly reflect expectations of how much inflation will erode the value of their fixed payments over the life of the bond or note. These expectations may shift as a result of changes in monetary policy. Increases in the fed funds rate, for example, should put a damper on economic growth, keeping inflation from heating up. Lower inflation expectations mean higher long-term bond prices and lower yields. Conversely, cuts in the fed funds rate should stimulate economic growth, at the risk of an increase in inflation. Higher inflation expectations mean lower long-term bond prices and higher yields.

Why Does a Long-Maturity Treasury Experience a Bigger Price Change Than a Short-Maturity One When Their Yields Change by the Same Amount?

A bond's price is linked to its yield in the following way: The price is the sum of the present value of all future payments from the bond. The present value of the future payments is calculated by discounting them. The rate used to discount them is the yield.

A change in yield of a certain magnitude (say, 25 basis points) has a larger effect on the price of a long-maturity issue than a short-maturity issue because the long-maturity issue makes more future payments, so the discounting process takes a larger toll.

For example, suppose a two-year note and a 10-year note experience identical changes in yield. The two-year note carries a 6% coupon and starts at a price of 100, to yield 6%. The 10-year note carries a 7% coupon and starts at a price of 100, to yield 7%.

The two-year note's yield rises to 6.25% and the 10-year note's yield rises to 7.25%. The 25 basis-point increase in yield causes the two-year note's price to fall 15/32 to 99 17/32. But it causes the 10-year note's price to fall 1 24/32 to 98 8/32.

The 10-year's price falls more because the higher rate at which future payments are now being discounted is applied to more payments -- 20 semiannual interest payments and the final repayment of principal, compared with just four semiannual interest payments and the final repayment of principal for the two-year bond.