First let's ensure we understand the basics of bonds.
Bonds are an application of debt. Each time a company or 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 benefit of bonds to the borrower is a bank will usually require payments on the principle of the loan along with the interest, so your loan gradually gets paid off. Bonds enable the borrower to only pay the interest whilst having the utilization of the whole number of the loan before the bond matures in 20 or 30 years (when the whole amount should be returned at maturity).
Two main factors determine the interest rate the bonds will yield.
If demand for the bonds is high, issuers will not 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 an increased interest rate on loans, so a business or government that is an undesirable credit risk has to pay an increased yield on its bonds in order to entice investors to get them.
An issue that surveys show many investors do not understand, is that bond prices move opposite with their yields. That's, when yields rise the purchase price or value of bonds declines, and in another direction, when yields are falling, bond prices rise.
Exactly why is that?
Consider an investor having a 30-year bond bought several years ago when bonds were paying 6% yields. He wants to market the bond rather than hold it to maturity. Say that yields on new bonds have fallen to 3%. Investors would obviously be willing to pay considerably more for his bond than for a brand new bond issue in order to get the larger 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 in the market decline if yields begin to go up, because investors will probably pay less for them than for the brand new bonds which will give them an increased yield.
Prices of U.S. Treasury bonds have already been particularly volatile throughout the last three years. Demand for them as a safe haven has surged up in periods when the stock market declined, or when the Euro-zone debt crisis periodically moved back to the headlines. And demand for bonds has dropped off in periods when the stock market was in rally mode, or it appeared that the Euro-zone debt crisis have been kicked later on by new efforts to create it under control. invest in bonds
Meanwhile, in the backdrop the U.S. Federal Reserve has affected bond yields and prices having its QE2 and 'operation twist' efforts to hold interest rates at historic lows.
As a result of the frequently changing conditions and safe-haven demand, bonds have provided as much opportunity for gains and losses whilst the stock market, if not more.
For instance, just since mid-2008, bond etfs holding 20-year U.S. treasury bonds have experienced four rallies in that they gained around 40.4%. The tiniest rally produced a gain of 13.1%.
But these were not buy and hold type situations. Each lasted only from 4 to 8 months, and then a gains were completely recinded in corrections by which bond prices plunged back with their previous lows.
Lately, the decline in the stock market during the summer months, accompanied by the re-appearance of the Euro-zone debt crisis, has had demand for U.S. Treasury bonds soaring again as a safe haven.
The result is that bond costs are again spiked up to overbought levels, for instance above their 30-week moving averages, where they are at high risk again of serious correction. In fact they are already struggling, with a potential double-top forming at the long-term significant resistance level at their late 2008 high.
Below are a few reasons, along with the technical condition shown on the charts, to expect a significant correction in the price tag on bonds.
The current rally has lasted about so long as previous rallies did, even throughout the 2008 financial meltdown. Bond yields are at historic low levels with very little room to maneuver lower. The stock market in its favorable season, and in a brand new leg up following its significant summer correction. Unprecedented efforts are underway in Europe to create 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 likely bring relief by at the least kicking the crisis down the road.
Holdings designed to maneuver opposite to the direction of bonds and therefore produce profits in bond corrections, range from the ProShares Short 7-10yr bond etf, symbol TBX, and ProShares Short 20-yr bond, symbol TBF. For anyone planning 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 maneuver twice as much in the opposite direction to bonds. And even triple-leveraged inverse etf's including the Direxion 20+-yr treasury Bear 3x etf, symbol TMV, and Direxion Daily 7-10 Treasury Bear 3X, symbol TYO.
