How Bond101 works

Most everyone knows that over the long-run, nothing beats the stock market. This being the case, why would anyone invest in bonds?Although they pale in comparison to equities in the long run, bonds have several traits that stocks simply can't match.

• First, capital preservation. Unless a company goes bankrupt, a bondholder can be almost completely certain that they will receive the amount they originally invested. Stocks, which are subordinate to bonds, bear the brunt of unfavorable developments.

• Bonds pay interest at set intervals of time, which can provide valuable income for retired couples, individuals, or those who need the cash flow. For instance, if someone owned $100,000 worth of bonds that paid 8% interest annually (that would be $8,000 yearly), a fraction of that interest would be sent to the bondholder either monthly or quarterly, giving them money to live on or invest elsewhere.

• Bonds can also have large tax advantage for some people. When a government or municipality issues various types of bonds to raise money to build bridges, roads, etc., the interest that is earned is tax exempt. This can be especially advantageous for those whom are retired or want to minimize their total tax liability.

How Do Bonds Interact with the Stock Market?

It is a general rule of thumb that bonds and stocks move in the opposite directions. In other words, when stocks go up in value, bonds go down. This is because stocks generally do well when the economy is booming.

• When the economy starts to decline, companies’ earnings will drop, and stock prices will plummet -- this is when investors want the safe interest payments guaranteed by bonds.

• Sometimes both stocks and bonds go up in value at the same time. This is usually because there is too much money, or liquidity, chasing too few investments, as is the case at the top of a market.

• The second case when some investors are optimistic about the economy’s future, and buying stocks, while others are pessimistic and buying bonds.

How Do Bonds Impact the US Economy?

Treasury bonds impact the economy by providing extra spending money for the government and consumers. This is because Treasury bonds are essentially a loan to the government that is usually purchased by domestic consumers. However, for a variety of reasons, foreign governments have been purchasing a larger percentage of Treasury bonds, in effect providing the U.S. government with a loan.

• This allows the government to spend more, which stimulates the economy.

• Treasury Bonds also help the consumer. When there is a great demand for bonds, it lowers the interest rate because the U.S. government doesn’t have to offer as much to attract buyers

• Lower interest rates on bonds means lower interest rates on mortgages. This allows homeowners to afford more expensive homes.

How Do Bonds Affect Mortgage Interest Rates?

Investors who purchase Treasury note would also be in the market for mortgage-backed. These are the mortgages that banks loan, but rather than hold them for 15 to 30 years, the banks sell the mortgages to the secondary market.

• Banks generally keep interest rates on mortgages only a few points higher than Treasury notes. Since Treasury notes have no risk, they can afford to offer lower rates.

• Lower interest rates on U.S. Treasury notes mean lower rates on mortgages. This allows homeowners to afford a larger home, and renters to afford their first home. This increased demand stimulates the real estate market, which stimulates the economy.

• Lower mortgage rates also allows homeowners to afford a second mortgage, which allows them to purchase more consumer products. This also stimulates the economy.