Beginner’s guide to the bond market

To help make sense of the number that’s spooking markets, here’s a beginners guide to understanding the bond market:

What are bonds? Bonds are a fixed interest investment — like a bank deposit except that the investment is recorded as a promise of repayment which can be onsold on a secondary market. Why are bonds popular? For Governments and other large institutions they are a secure method of borrowing money directly from the public. Their use dates back to the 1590s. For investors they are considered a safe bet given the level of risk is tied to the quality and reputation of issuer — often a state government. The US Government has around $30 trillion of bonds on issue. How are yields set? Generally, bond yields fall when economic conditions worsen. Economic conditions that might decrease bond yields include high rates of unemployment and slow economic growth or recession. Right now the US economy is improving and there are signs of some inflation which is causing yields to rise. But what about bond prices? That is the confusing bit. Bonds are both fixed interest investments and tradeable. Price and the yield on a bond move in different directions — so if the price falls the yield rises and vice versa — in order to keep the return on the investment in sync with the price. Why do bonds matter? Bonds determine what it costs a government to borrow. When a government issues new bonds, it has to pay an interest rate on those bonds that is acceptable to the market. Why are stock markets spooked? As bond yields rise they start to look like better value for investors with less risk than equities. Money starts to move from sharemarkets to bonds. Markets fear a tipping point which will see a major sell off from equities. Why should three per cent be the tipping point? There is no inherent reason. But it has become a point of focus for investors as they watch new economic conditions unfold.