Might Be A Great Time To Be A Bond Bear

First let�s make sure we understand the basics of bonds.

Bonds are a form of debt. When a company or a government needs to borrow money it can borrow from banks and pay interest on the loan, or it can borrow from investors by issuing bonds and paying interest on the bonds.

One advantage of bonds to the borrower is that a bank will usually require payments on the principal of the loan in addition to the interest, so that the loan gradually gets paid off. Bonds allow the borrower to only pay the interest while having the use of the entire amount of the loan until the bond matures in 20 or 30 years (when the entire amount must be returned at maturity).

Two main factors determine the interest rate the bonds will yield.

If demand for the bonds is high, issuers will not have to pay as high a yield to entice enough investors to buy the offering. If demand is low they will have to pay higher yields to attract investors.

The other influence on yields is risk. Just as a poor credit risk has to pay banks a higher interest rate on loans, so a company or government that is a poor credit risk has to pay a higher yield on its bonds in order to entice investors to buy them.

A factor that surveys show many investors do not understand, is that bond prices move opposite to their yields. That is, when yields rise the price or value of bonds declines, and in the other direction, when yields are falling, bond prices rise.

Why is that?

Consider an investor owning a 30-year bond bought several years ago when bonds were paying 6% yields. He wants to sell the bond rather than hold it to maturity. Say that yields on new bonds have fallen to 3%. Investors would obviously be willing to pay considerably more for his bond than for a new bond issue in order to get the higher interest rate.

So as yields for new bonds decline the prices of existing bonds go up. In the other direction, bonds bought when their yields are low will see their value in the market decline if yields begin to rise, because investors will pay less for them than for the new bonds that will give them a higher yield.