First let's make sure we understand the basics of bonds.
Bonds are a form of debt. Each time a company or perhaps a government needs to borrow money it could borrow from banks and pay interest on the loan, or it could borrow from investors by issuing bonds and paying interest on the bonds.
One advantageous asset of bonds to the borrower is that the bank will often require payments on the principle of the loan as well as the interest, so your loan gradually gets paid off. Bonds permit the borrower to only pay the interest while having the usage of the whole amount of the loan before the bond matures in 20 or 30 years (when the whole amount must be returned at maturity).
Two main factors determine the interest rate the bonds will yield. bonds
If demand for the bonds is high, issuers won't have to pay as high a yield to entice enough investors to get the offering. If demand is low they will have to pay higher yields to attract investors.
The other influence on yields is risk. In the same way an undesirable credit risk has to pay banks a greater interest rate on loans, so a business or government that is an undesirable credit risk has to pay a greater yield on its bonds to be able to entice investors to get them.
An issue that surveys show many investors do not understand, is that bond prices move opposite for their yields. That's, when yields rise the cost or value of bonds declines, and in another direction, when yields are falling, bond prices rise.
How come that?
Consider an investor having a 30-year bond bought several years back when bonds were paying 6% yields. He wants to sell the bond as opposed to hold it to maturity. Say that yields on new bonds have fallen to 3%. Investors would obviously be willing to pay significantly more for his bond than for a fresh bond issue to be able to get the higher interest rate. So as yields for new bonds decline the prices of existing bonds go up. In another direction, bonds bought when their yields are low might find their value on the market decline if yields begin to rise, because investors will pay less for them than for the newest bonds that may provide them with a greater yield.
Prices of U.S. Treasury bonds have now been particularly volatile during the last three years. Demand for them as a secure haven has surged up in periods once the stock market declined, or once the Euro-zone debt crisis periodically moved back in the headlines. And demand for bonds has dropped off in periods once the stock market was in rally mode, or it appeared that the Euro-zone debt crisis had been kicked in the future by new efforts to bring it under control.
Meanwhile, in the background the U.S. Federal Reserve has affected bond yields and prices using its QE2 and 'operation twist' efforts to keep interest rates at historic lows.
As a result of the frequently changing conditions and safe-haven demand, bonds have provided the maximum amount of chance for gains and losses since the stock market, or even more.
As an example, just since mid-2008, bond etfs holding 20-year U.S. treasury bonds have observed four rallies in which they gained as much as 40.4%. The tiniest rally produced a gain of 13.1%.
But they were not buy and hold type situations. Each lasted only from 4 to 8 months, and then a gains were completely removed in corrections in which bond prices plunged back for their previous lows.
Lately, the decline in the stock market during the summer months, followed closely by the re-appearance of the Euro-zone debt crisis, has received demand for U.S. Treasury bonds soaring again as a secure haven.
The result is that bond costs are again spiked as much as overbought levels, for instance above their 30-week moving averages, where they are at high risk again of serious correction. Actually they are already struggling, with a potential double-top forming at the long-term significant resistance level at their late 2008 high.
Here are a few reasons, as well as the technical condition shown on the charts, to expect a significant correction in the price of bonds.
The existing rally has lasted about so long as previous rallies did, even through the 2008 financial meltdown. Bond yields are at historic low levels with hardly any room to move lower. The stock market in its favorable season, and in a fresh leg up as a result of its significant summer correction. Unprecedented efforts are underway in Europe to bring the Euro-zone debt crisis under control. And this week those efforts were joined by supportive coordinated efforts by major global central banks that will probably bring relief by at the least kicking the crisis down the road.
Holdings designed to move opposite to the direction of bonds and therefore produce profits in bond corrections, include the ProShares Short 7-10yr bond etf, symbol TBX, and ProShares Short 20-yr bond, symbol TBF. For anyone attempting to take the additional risk, you will find inverse bond etfs leveraged two to one, including ProShares UltraShort 20-yr treasuries, symbol TBT, and UltraShort 7-10 yr treasuries, symbol TBZ, designed to move two times as much in the opposite direction to bonds. And even triple-leveraged inverse etf's such as the Direxion 20+-yr treasury Bear 3x etf, symbol TMV, and Direxion Daily 7-10 Treasury Bear 3X, symbol TYO.
