How Do Economic Indicators Predict Bond Performance?

How Do Economic Indicators Predict Bond Performance?

There are varieties of indicators that help investors track a bond’s value and market performance. Generally, a bond’s price on the secondary market depends on how its coupon rate compares with current interest rates.

The rate of interest stated on a bond certificate is known as the bond’s coupon rate. A $1,000 bond with a coupon rate of 5 percent initially pays $50 a year.

How interest rates interact with bond prices

Because interest rates change, coupon payments sometimes fall below market interest rates. When a bond’s coupon falls below market interest rates, the bond price also falls to provide the market with a consistent yield (return). Money received from coupon payments on lower-interest bonds can be used to buy newer bonds with higher yields. When interest rates fall, companies sell new bonds at the lower rate and then buy back their older, more expensive bonds with money from this sale. You may then be forced to purchase lower-returning bonds.

With all these price changes, how can you tell whether the bond you are buying is really a good investment? Yield-to-maturity (YTM) measures the total return on a bond over its entire lifespan. It tells you how much you will make on the bond if you hold it until maturity or until it is called (bought back). YTM includes any coupon payments as well as any loss or gain you incurred from buying the bond above or below its face value.

How maturity relates to yield

There is a direct connection between a bond’s yield and its maturity. The longer it takes a bond to mature, the higher the risk that prices will fluctuate. The higher the risk, the higher the bond’s possible yield. This link is measured by a yield curve that measures the yields of bonds with different maturities, from shortest to longest. If the curve is steep, you can obtain higher yields by purchasing bonds with longer maturities. If the curve is inverted, short-term bonds are a better deal and interest rates are expected to decline.

Because bond prices are so sensitive to changes in interest rates, which are themselves affected by general economic trends and the government’s fiscal policy, your bond trading strategy will largely be determined by how you believe the economy will perform over the course of years.