Each day in the bond market, the future economic hopes of entire countries are negotiated as every tick of every interest basis point is speculated on by traders. Economic reports often act as a match to dynamite, resulting in explosive flurries of buying and selling as bond traders double-down or hedge risks on the future prospects of nations.
The risks are incredible, but so is the profit potential. However, to take advantage, you must have a solid trading approach combined with sound risk control. Fortunately, bonds trade in an event-driven market where economic reports result in predictable patterns that manifest in a bond's price action and can result in a solid stream of profitable opportunities.
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To capitalize on those opportunities, you must understand both how bond yields work and why they are critical to helping you profit across a broad breadth of asset classes.
Yields reveal the way
The U.S. Treasury conducts a number of bond auctions during the fiscal year to raise money to fund the various arms of the government as well as provide public services to its people. With the ability to print its own money as well as raise revenue in various types of taxes, the United States is a stable country with a strong economy that offers you, the investor, a strong guarantee that it has both the ability and the willingness to repay its debt to you, the bond-holder.
One of the instruments that it auctions is the 10-year Treasury note (T-note).
These notes are sold in $100 increments. For each sold, the U.S. government pledges to pay back $100 to the holder at a maturity date of 10 years from the time it was issued. These notes also have a fixed rate of interest that the Treasury sets at the time of the auction to give potential holders the incentive of a premium.
This premium, or interest rate, multiplied by the face value of the note, results in the expected yield for that particular note. So, if the United States is offering 3.50% on a $100 10-year T-note, then your expected yield is $35.
However, initial bond holders may decide to raise capital by selling their holdings of the T-note on the open market. Based on the current interest rate, they may have to entice prospective buyers. If this is the case, then the sellers may have to sell their T-notes at a lower price. This effectively raises the yield, which is a fixed 3.50% on the $100 face value, to attract those buyers.
Based on this example, a T-note owner may offer his or her note for a discount at $95--effectively raising the yield to 3.70%. This higher yield attracts more risk-averse investors who seek out the closest thing to a guaranteed return that they can find in the form of the lower-priced investment of the T-note at the highest yield possible.
As time goes on, equities may offer attractive yields of their own in the form of dividends as well as the added benefit of potential increases in share value. Once the general market begins to experience a bull run, former risk-averse investors may grow more willing to accept a higher level of risk in the hopes of seeking out higher returns in the stock market. This shift in interest can signal to traders that it's time to get back in the market (see "From bonds to stocks," right).
Soon, a pattern begins to appear as investors begin to move from risk averse assets, such as bonds, to higher risk/ higher return alternative assets, such as the stock market.
A cycle is played out in the markets, over and over again, where investor sentiment causes an investor to gravitate from one asset class to the other based on the pursuit of two things: Higher returns on acceptable risk and a flight to safety to get away from risk.
First, understand that bond yields move inversely to bond prices, but move in tandem with the stock market, though not in lock-step. …