The bond market (also called the debt market or credit market) is a financial market in which the participants are provided with the issuance and trading of debt securities. This primarily includes government-issued securities and corporate debt securities, facilitating the transfer of capital from savers to the issuers or organisations requiring capital for government projects, business expansions and ongoing operations.
Bonds can act, and are typically used as a portfolio diversifier.
Whilst some economists may believe that the current long period of global growth may be coming to an end, holding secure assets as part of an overall strategy, may provide a defensive position. Also, taking into consideration recent central bank interest rate rises (with more expected), bond returns could be deemed to be under threat. However, recent bond returns have been surprising with losses being limited.
So where can a bond investor find opportunities against such a backdrop? Caution may provide a sensible approach. Higher interest rates usually mean lower bond prices, but not necessarily negative total returns. As long as rates rise gradually and not by too much, bond investors can still make money if the coupon income (the yield paid by the bond) exceeds overall price declines. Therefore, high-quality bonds can still provide a good counterbalance in your portfolio in the event of a stock market reversal.
Bond investments are generally seen as being ‘smart money’ and less prone to the type of speculation seen in stocks or commodities. As a result, bonds actually do have a fairly strong track record as an economic predictor, and for that reason, they are often used by economists as a leading indicator. If nothing else, the bond market can provide a gauge of the consensus expectation regarding the economy at any given point, even if that expectation sometimes proves incorrect.
The best way to use bonds to predict the economy is to look at the yield curve.
The yield curve represents the yields paid by bonds of varying maturities (typically from 3 months to 30 years) plotted on a graph. This will typically slope upward, since investors demand higher yields for longer-term bonds. Since yields for bonds of all maturities change every day due to market fluctuations, the shape of the yield curve is always changing and these changes provide an insight into the economic outlook.
The performance of short-term bonds (those with maturities of 2 years or less) are most directly impacted by expectations regarding future central bank policies with regard interest rate movements. In contrast, the performance of longer-term bonds (which are more volatile than their short-term counterparts) are largely driven by the outlook for inflation and economic growth. The important aspect of this relationship is that while short-term yields are pinned to some extent by expectations for rate policy, longer-term bonds experience higher volatility based on shifts in the broader outlook.
Expectations for the economy, therefore tend to have a strong influence on the shape of the yield curve. In summary, a yield curve that is steep or becoming steeper is a sign of expectations for improving growth; whilst a yield curve that is flat (or becoming flatter) is a sign of expectations for slowing growth.
The yield curve can be used as a tool, but be wary that it can give false signals. Like any freely traded financial asset, bonds can be influenced by central bank policy, investor emotions, and other undetermined factors.