Trading Bonds-63

Financial Markets For The Rest Of Us
An Easy Guide To Money, Bonds, Futures, Stocks, Options, And Mutual Funds

Page 63

suggestions or indications of a severe slowdown. Let’s take a closer look at how bad economic news can impact the price of bonds.

Inflationary Threat — A continually overheated economy leads to unhealthy inflation, causing the value of the money, and therefore the bonds, to erode. The problem is that under an inflationary condition, bonds must make higher interest payments to offset inflation. Therefore bond prices drop as investors offer less money for them. As bond prices drop, their yields, moving in the opposite direction, rise until their prices settle at a point where traders believe it can be justified given the rate of inflation. You may, for example, hear that the price of the long bond dropping (and therefore its yield rising by a number of basis points) in response to fewer than expected jobless claims, higher than expected CPI, stronger than expected housing starts, and other news. These pieces of news, collectively or individually, could indicate too strong of an economy and signal inflationary conditions, causing bond prices to drop.
Slowdown Threat — Just as the threat of inflation has a negative effect on bonds, causing them to lose value, a rapidly shrinking economy would see its bonds faced with the same kind of repercussions. In this case bonds issued within such economy lose their appeal, causing a broad sell-off resulting in steep price drops. Economies with massive debt, political turmoil, or over-valued currencies would experience such an effect, as these conditions point to economic breakdown or trouble looming ahead. Worse yet, such economies face an added threat of having their bond ratings lowered to junk status causing a greater sell-off. These bonds may end up with yields upwards of 50% but they run a high risk of default.

Flight To Quality
Investors are always on the lookout to place their money in quality instruments. This means that when one instrument becomes more …