All things evolve and so did the bond market. What started out as a simple way for governments and companies to gain cash, has grown into something much larger.
Now the bond market affects the whole finance world. From how asset prices are set to how money flows around the world. Let’s look at how that happens.
Bond Market and Security Prices
Investing is a function of two things:
- Understanding the relationship between risk and reward.
- Knowing when an asset’s price is appropriate versus the risk you are taking.
Bonds are an important part in how investors view both.
How Bonds Change Investor View on Assets
Because bonds have a predetermined cash payment schedule and maturity date. Investors can use a valuation formula to determine if the current price of the bond they are looking at is worth owning for their needs. Straightforward analysis.
When an investor is looking at other assets - stocks, real estate, private companies etc. There are many variables that go into calculating current and future expected value. Current and future cash flows for example. Because of this uncertainty, calculating valuations becomes more difficult.
If the analysis of the non bond asset presents the likelihood of a favorable investment outcome. The investor may place their chips on that asset over a bond.
Over time investors monitor and re-evaluate their investments/assets. During re-evaluation similar analysis that got them to purchase the asset is redone. If variables have changed, like bond rates, what previously was an interesting investment may now not look as good. In that situation, the investor may decide to sell the non bond asset.
This process of analyzing assets consistently and then changing between assets is called rotation. Rotation is what keeps some assets in favor and rising in price. While others falter and go lower in price.
This rotation process is happening constantly. Being aware how different assets react to bond rate changes is crucial. It can help you find assets that are poised to appreciate. Or help you exit investments that can hurt you when rates change.
Bond Markets Anchor the Money Flow
“Earnings do not move the overall markets; It’s the Federal Reserve. And whatever I do, focus on the central banks and focus on the movement of liquidity…..it’s liquidity that moves markets.” - Stanley Druckenmiller
The reason you focus on the central banks is because they set short term rates which all other bond rates are based on.
In times when they set rates at low levels - like currently - the cost of capital is cheap and the desire is high. Companies take advantage of this and get cheap funding to retire more expensive debt obligations (like you do with a mortgage refi) or use the funding for future growth.
In times when rates are set at higher levels. The cost of capital rises so corporations start pulling back on borrowing. This in turn slows down the flow of money to expansion and growth projects.
Because central banks can change the rates the bond market pays. They, and the bond market, set where money flows in the world. Both for corporations and individuals.