The mysterious world of bonds

The bond market is only happy when it rains. To a bond trader, a rip-snorting economy brings the risk of inflation, and bond traders view inflation the same way surfers view sharks.

Here’s why. A bond is a long-term, interest-bearing IOU. If you had bought a $10,000 10-year Treasury note at the last auction, you’d get $175 a year in interest.

When the note matured, you’d get your $10,000 back. The government guarantees interest and principal on Treasury securities, so Treasuries are considered free from the risk of default.

Inflation would erode the value of your interest payments. After a decade of 3% inflation, $175 would have the buying power of $129.

If interest rates rise, you can’t go back to the Treasury and ask for a higher interest rate: A deal is a deal. If rates fell and you had to sell your T-note before it matured, traders would pay extra for the T-note to reflect current rates.

Let’s look at what would happen to the market value of the bond above if rates fell to 1%. A trader would have to offer about $10,700 to attract your interest. ($175 annual payment divided by $10,700 gives a yield to maturity of about 1%.)

Now let’s see what would happen if interest rates rose to 3%. You’d have to slash your bond’s price to $8,930 to make the yield equal 3%.

Bond market cycles typically don’t move swiftly, but they do last a long time. Interest rates have been falling since 1981, and bond prices have been rising since then. In the last bear market for bonds, traders called Treasury bonds “certificates of confiscation” because long-term bond holders lost money for a long time.