Forecasting market direction is never a sure thing. However, there are a few economic links that can assist you to make consistent profits. One of the most important of these is the relationship between interest rates and bond prices, which brings us to the question of why bonds fluctuate in value.
Firstly, a bond is a debt instrument sold by corporations or governments to raise money for various reasons. A bond promises to pay its holders periodic interest at a fixed rate (the coupon), and to repay the principal of the loan at maturity. Bonds are issued with a par or face value (or principal) and are traded based on their interest rates.
These bonds don’t necessarily have to be held by the same buyer until maturity. Instead, they can be traded on the open market at a price that fluctuates according to interest rates and inflation. Since a bond’s interest rate remains the same until maturity, its real value at maturity depends on the real value of the dollar at repayment, taking inflation into account.
Bond yields follow the economy and are interest rate-driven. If interest rates go up, bond prices go down, and if interest rates decline, bond prices rise. An example of this is, you decide to buy a bond for $1000. I agree to pay the yield (return you get on an investment) of 8% each year. I will pay you $80 interest per year. If interest rates rise to 10% which would bring in $100 per year you have lost the opportunity to receive the higher rate of interest. The first loan’s value declined. If you want to sell that 8% bond as an investment, you will find that its value has decreased. This concludes, when interest rates go up, bond (loan) prices fall.
The same with the converse situation: When interest rates go down, bond prices rise. If the interest rate dropped from 8% to 5%, and investor could receive only $50 on the $1000 investment. A previous loan with an 8% interest rate would now increase in value, because it would make the investor $80 per year instead of $50 per year. This shows that fluctuations in interest rate stimulate the bond market. Trading bond options can be quite lucrative if you take heed to interest rates and inflation.
It is a good practice to monitor certain bond markets’ yield to maturity. This can predict bond’s return over time by assessing its interest rate, price, par value, and time until maturity.
If you watch the day-to-day changes in the stock market, you may find that investors and traders are watching bond prices and interest rates very closely. Changes in either direction affect whether it is a good time to buy or sell bonds. If bond prices drop too much and yields climb too high, this will create competition for shares because bonds offer a better percentage return or, it can devastate the stock market.
When bond yields go up, companies have to pay more to borrow from banks, which hurt their profits. Investors are also concerned about the earnings of a company. If earnings are better than expected, they can override rising bond yields and cause stocks to go up. When traders aren’t focused on earnings reports which are released quarterly, they often focus on bond yields