First let's make sure we understand the basics of bonds.
Bonds are a questionnaire of debt. When a company or perhaps a government must borrow money it may borrow from banks and pay interest on the loan, or it may borrow from investors by issuing bonds and paying interest on the bonds.
One benefit of bonds to the borrower is that the bank will often require payments on the principle of the loan in addition to the interest, so the loan gradually gets paid off. Bonds permit the borrower to only pay the interest whilst having the use of the entire quantity of the loan before bond matures in 20 or 30 years (when the entire amount must be returned at maturity).
Two main factors determine the interest rate the bonds will yield.
If demand for the bonds is high, issuers won't have to pay for as high a yield to entice enough investors to buy the offering. If demand is low they will have to pay higher yields to attract investors.
One other influence on yields is risk. Just like a poor credit risk has to pay for banks a higher interest rate on loans, so a business or government that is a poor credit risk has to pay for a higher yield on its bonds in order to entice investors to buy them.
A factor that surveys show many investors do not understand, is that bond prices move opposite with their yields. That is, when yields rise the purchase price or value of bonds declines, and in the other direction, when yields are falling, bond prices rise.
How come that?
Consider an investor owning a 30-year bond bought several years back when bonds were paying 6% yields. He wants to market the bond as opposed to hold it to maturity. Claim that yields on new bonds have fallen to 3%. Investors would obviously be willing to pay for somewhat more for his bond than for a fresh bond issue in order to get the higher interest rate. In order yields for new bonds decline the values of existing bonds go up. In the other direction, bonds bought when their yields are low might find their value on the market decline if yields begin to go up, because investors will probably pay less for them than for the new bonds that will give them a higher yield. bonds to invest in
Prices of U.S. Treasury bonds have been particularly volatile over 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 in 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 in the future by new efforts to bring it under control.
Meanwhile, in the backdrop the U.S. Federal Reserve has affected bond yields and prices having its QE2 and 'operation twist' efforts to put on interest rates at historic lows.
Consequently of the frequently changing conditions and safe-haven demand, bonds have provided as much chance for gains and losses as 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 that they gained around 40.4%. The smallest 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 removed in corrections where bond prices plunged back with their previous lows.
Most recently, the decline in the stock market during the summertime 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 safe haven.
The result is that bond costs are again spiked around overbought levels, for instance above their 30-week moving averages, where they're at high risk again of serious correction. In reality they're already struggling, with a potential double-top forming at the long-term significant resistance level at their late 2008 high.
Here are some reasons, in addition to the technical condition shown on the charts, to expect an important correction in the buying price of bonds.
The existing rally has lasted about so long as previous rallies did, even through the 2008 financial meltdown. Bond yields are in historic low levels with hardly any room to go 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 likely bring relief by at the least kicking the crisis down the road.
Holdings designed to go 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 can 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 go twice as much in the contrary 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.
