Sooner or later, just about everyone needs to borrow money. Modern economies probably could not survive without the means to loan and borrow. When a government or company wishes to borrow money, they sell bonds to the public. Bonds are IOUs which represent a promise to repay a loan plus interest after a specific period of time.
After being issued, bonds can be traded on the open market. The bond market is second only to the currency market in size. Loaning and borrowing money is big business.
What makes bonds interesting is that the cost of bonds is affected by interest rates, and vice versa--and interest rates directly affect the economy. If investors are buying bonds and driving up bond prices, they are also driving down interest rates. If bond prices are dropping, interest rates rise. Since interest rates are essentially the cost of borrowing money, the bond market directly affects the availability of money in the economy.
Bonds are considered the safest of the four main markets. Some bonds, namely U.S. Treasuries, are considered the safest investment in the world. However, with the United States' debt woes this might be changing. Regardless, safe doesn't mean risk-free. Although repayment plus interest is guaranteed at the end of the bond's term, there is always the chance that the issuer could default.
Also, if the bond holder does not wish to hold the bond fully to maturity, he must sell the bond on the open market, where an increase in interest rates may have driven the bond's price below the amount he paid for it. Of course, the bond price may have risen during this time, too. But there is no guarantee of this.
Several things can cause bond prices to rise. Prices will rise when investors feel the bond issuer, whether a government or company, is strengthening. If the Fed lowers interest rates to stimulate growth, existing bond prices will rise, because they will then offer a higher yield relative to new interest rates.
Also, bonds are considered a safe haven in uncertain times. So sometimes when the stock market goes down, the bond market will go up. This due the "flight to safety" effect. Investors are selling stocks and putting the money into bonds because they feel bonds are a safer investment, at least at that moment.
Another factor to consider with bonds is inflation. When inflation begins to become a problem, interest rates rise to compensate for money being too available. This drives the price of bonds down. But falling bond prices could be looked at in another way--that demand for bonds is waning because of lack of faith in the issuer. If these are government bonds, then if foreigners are selling them they are likely selling our currency, too, to convert the money back into their own currency. This would drive the value of our dollar down, which would exacerbate inflation, causing interest rates to rise more and bonds to fall more. In other words, a chain reaction.
That is how a crash happens, and there may be one of those in the United State's future if we cannot pay our debts and a run on our bonds breaks out.
I'll talk more about bonds in the coming segments.
Next up: Stocks
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