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First, a confession: Interest rates are unpredictable. But then, you knew that already. Fortunately, they’re not entirely unpredictable. Good bets are possible.

But before discussing some of the factors influencing them, a few words about why you should care: Price-Yield correlation. Which means what, now? As interest rates rise, bond prices fall. When rates fall, prices rise. Common sense reveals the reason.

Suppose a $1000 bond carries a 5% interest rate, and therefore pays two $25 semi-annual interest payments. If interest rates rise to 7%, several things can happen.

Anyone holding that bond seeking to sell will be forced to offload at a discount. Current potential buyers can get 7% ($70 per year) elsewhere. (Assuming similar credit risk and maturity.) Second, the holder can experience pressure to sell, since they’re losing the opportunity to make an extra 2% per year.

If interest rates fall, bond prices for existing or new issues rise. Run the same argument, just reverse the arithmetic.

So, predicting interest rate movements – both when considering a new bond purchase and when debating when or whether to sell – has consequences for determining real yields. (Current Yield = Annual Interest Amount/Current Price. For more accurate estimates, see the ‘Calculating Bond Yields’ article.)

Now, what causes them to move? Naturally, the answer is: many things, any one of which has its own set of complex causes. Let’s simplify.

For good or ill, U.S. Treasury securities have a significant impact on general bond rates. Their rates in turn are influenced by (and made somewhat predicatble by) GDP (in Europe, GNI), CPI, PPI and a variety of other economic indicators.

GDP is the Gross Domestic Product, the total output of goods and services produced in the U.S. (In Europe, they have the good sense to calculate it per capita, in order to adjust for differences in population, where it’s known as GNI, Gross National Income.)

Large unexpected changes motivate the Fed (the U.S. Federal Reserve Bank) to adjust short-term rates up or down. That change influences short-term bond rates, since bonds compete with other possible investments.

CPI (Consumer Price Index) is a measure of the average change over time in prices of a select group of goods and one of the major measures of inflation. (Unfortunately, it doesn’t include the cost of food or energy, which is fine for those who don’t need to eat, heat their homes or travel anywhere.)

Since (most) bonds are issued with fixed interest rates, actual returns over time have to be calculated by subtracting the influence of inflation. 8% sounds like a healthy return until 4% inflation is subtracted, reducing the annual net return to 4%.

A higher than expected CPI influences bond prices to fall and interest rates to rise.

PPI: The Producer Price Index, which measures the average change over time in the prices recieved by domestic producers of goods and services. Somewhat the flip side of CPI, this measures price change from the seller’s perspective.

When higher than expected, PPI rises signal inflation, again causing bond prices to fall as interest rates rise.

Other factors influence rates, such as unemployment rates, housing starts (new housing construction begun) and others. How much any one (or all together) influence rates is an ongoing academic debate with more than academic consequences.

Nevertheless, certain trends stand out.

Interest rates on domestic bonds tend to move with Treasuries, and the 30-year mortgage rate on home loans historically runs about 1-2% above the yield on 30-year Treasury bonds.

When the Fed increases the Fed Funds rate, it does so by supplying short-term securities in the open-market. This tends to decrease the money supply, which increases short-term rates. Bonds with short maturities will therefore tend to have higher yields.

When the U.S. government borrows it does so by issuing longer-term Treasury bonds to institutional lenders. This tends to drive rates up on corporates, since higher risk instruments have to compete with the more low-risk Treasuries. (One available alternative is Eurobonds, since the European Central Bank tends to peg its rate a percent or more above the Fed. Competition is beneficial.)

How much any of these factors influences rates is best researched by studying the charts available via simple Internet searches. They don’t provide certainty, nothing in investing does, but bets based on sound data are as good as it gets.

It’s often said that government bonds represent one of the lowest possible risks for an investor. In general, true – but much depends on which government issues them and which investor is buying.

Government bonds are usually sold with the wording ‘Backed by the full faith and credit of the…’ So, estimating the risk becomes an exercise in determining how much faith one places in that credit.

The Iran government floats bonds targeting foreign investors, and some have profited, for example. But investing in a country likely to see significant political change at any time is taking a high risk. The investor, whether native or foreigner, generally has no recourse if the issuer defaults.

That said, there are a wide variety of choices for the investor seeking low risk investments that offer a modest return.

U.S. Treasuries

Bonds issued by the U.S. Treasury (hence the name) are rightly considered among the lowest risk investments. To date, they’ve never defaulted and there’s small likelihood they will anytime in the foreseeable future. Like any government issued bond, they’re backed by the ability to levy and collect income tax (or inflate the currency in order to lower the actual repayment cost) – an ability they’re unlikely to lose anytime soon.

T’s come in a variety of maturities (length before principal is repaid) and coupon (interest) rates.

Treasury Bills (13, 26 or 52 weeks) are auctioned on Mondays and the 52-week sells every four weeks. Minimum purchase amount is $1000, with interest paid at maturity for the 13 and 26 week, and at the half-way point and maturity for the 52 week.

Treasury Notes are intermediate length bonds with maturities of 2-year, 5-year and 10-years, again sold in minimum amounts of $1000. Two-years are sold monthly, 5 and 10-year notes every three months starting in February. Like most bonds, interest is paid semi-annually.

Treasury Bonds of the 30-year variety are available in February, August and November at $1000 each with interest paid every six months.

Once sold their price will vary on the open market as buyers and sellers bid and compare against other similar instruments. Longer-term bonds tend to have greater price changes than shorter-term bonds, owing to a number of factors including the uncertainty of future interest rates, general economic forecasts and political events, etc.

To calculate the current yield (as with any bond) divide the interest rate by the current price. For example, a $1000 bond that pays $46 per year in interest is $46/$1000 = 0.046 = 4.6%.

Since the coupon rate is fixed, this could have been read without being calculated. But, bond prices vary from par (face) value. So, even if the coupon rate were 4.6% if the bond sells ‘under 100′, i.e. at a discount to it’s original price, the yield can, and usually does, differ from the interest rate. A $1000 bond that sells for $950, for example, with a coupon rate of 4.6% will yield: 46/950 = 4.8%.

For investors looking for predictable cash flow at low risk, government bonds – whether U.S., Canada, UK, Germany, or other stable country – represent a viable investment.

Ask (Asked Price)
The lowest round-lot price a broker will offer to sell a security.

Auction
The issuance of new Treasury bills, notes and bonds at stated intervals by the Federal Reserve Bank of the U.S.

Baby Bond
Bond with a face value of less than $1,000.

Basis Points
1/100th of a percentage point of yield.

Bid
The highest price offered for a security at a given time.

Bond
A debt security of a corporation or government. Usually refers to those with long maturity periods (10 to 30 years).

Bond Fund
Type of mutual fund that invests primarily in bonds.

Callable
A bond feature that permits the issuer to redeem the bond earlier than maturity.

Convexity
Measure of the curvature of the price-yield relationship of a fixed-income security.

Conversion Ratio
Issue price of a convertible divided by the conversion price.

Convertible (Bond)
A bond that allows the holder to convert to common stock.

Coupon
The annual interest percentage paid on a bond.

Current Yield
Coupon payment divided by market price.

CUSIP (The Committee on Uniform Security Identification Procedure)
Each type of security is assigned a unique CUSIP number.

Debenture
A debt issued by a corporation that is secured only by the issuing company’s reputation, as distinguished from one backed by real assets.

Derivative Zeros
Zero coupon bonds created by stripping coupon and principal payments from a U.S. Treasury Security. (The coupon and bond are then sold separately.)

Discount
When the market price of a bond is lower than the original issue price (par).

Duration
A measure of the average time required to collect all payments of principal and interest.

Eurobonds
A bond issued in a currency other than that of the country of issue. Interest is usually non-taxed.

Face Value (par)
The amount that appears on the face of the certificate and that the issuer pays at maturity.

Hedge
To reduce the risk in one security by taking an offsetting position in another. (Hedging involves attempting to hold instruments whose prices tend to move in opposite directions.)

Intermediate-Term Bonds
Bonds with five to ten year maturity.

Maturity
The date on which a bond’s principal is to be repaid.

Modified Duration
A measure of the sensitivity of a bond’s price to changes in yields, shown as a number of years to maturity. (Example: If a bond has a modified duration of 4 years, for every 100 basis-point change in yield, the price changes by 4 percent in the opposite direction.)

Par – Face value
the original issue price of a bond.

Subordinated Debenture
A debenture whose claim to interest and principal of the corporation comes after those of regular debentures and other debt.

Tax Exempt Bonds
Municipal securities whose interest is free from Federal income tax.

Treasury Bills
Bonds issued by the U.S. Treasury with maturities of 13, 26 or 52 weeks.

Treasury Bond
U.S. bonds with maturities of 10 to 30 years.

Treasury Note
U.S. Bonds with 1 to 10 year maturities.

Volatility
Relative measure of a security’s price movement during a specific time.

Yield
The rate of return on an investment.

Yield Curve
A graph showing the general pattern of yields on bonds or other instrument.

Zero Coupon
A bond that pays zero interest. Sold at a discount to face value, the investor profits at maturity.

When even the Iranian government floats Eurobonds, you know there’s something funny about the term.

There’s a difference between a eurobond and a foreign bond, even from the perspective of a non-European. A Eurobond is a bond issued and traded in a country other than the one in which it’s currency is denominated.

Not all originate or circulate in Europe, though most are issued by non-European companies or governments to be traded by European investors. For example, the French government issues euro-denominated bonds (the Franc was discontinued in 2002) that buy and sell on Japanese financial markets. Issuers get creative. A Eurobond can be denominated in U.S. dollars, but issued in Japan by an Australian company. Even Wal-Mart issues bonds in U.S. dollars that trade on the German exchanges.

In fact, most new issues in the international bond market are Eurobonds and it’s now larger than the U.S. bond market. (The latter is over $14 trillion total.)

Eurobonds give issuers some additional tools for creative financing, since they can choose a country based on regulatory and tax environment. Investors benefit by having more to choose from.

Eurobonds do carry extra risk, though.

Most investors are moderately familiar with conditions in their own country. But even in this day of Internet-available international news and financial information, events elsewhere are usually much less well tracked.

Added to the natural ignorance of events far away is the significant risk of foreign currency trading. Compared to the size of currency markets, bond trading is small. The equivalent of over $1.5 trillion dollars per day changes hands in the foreign currency markets. By comparison, U.S. Treasury Securities trade around $360 billion per day.

And currency exchange is significantly more volatile – with wider price swings over shorter time frames and greater sensitivity to momentary political changes. Currency risk occurs on longer time frames as well, though.

A bond bought today generally matures a few years later. Suppose, a U.S. investor pays £1,000 (~$1,770 today, hence £1 GBP = $1.77USD today) for a new eurobond which is held to maturity and repaid five years later. When repaid, the issuer repays in GBP (British Pounds) on the face value, £1,000. But in the interim, the exchange rate has changed to £1 = $1.66. The investor will be paid back the equivalent of $1,660. (And this example ignores any complicating factors of local inflation.)

The $110 loss comes entirely from currency risk. Of course, the scales tip both ways. It’s possible, and just as likely, for currency rates to change in favor of the investor. The exchange rate may change so that £1 = $1.88.

But then the investment becomes one not merely of bond trading but currency speculation. Not a bad investment medium, millions make enormous sums that way every day, but a much riskier market.

As with any investment, research – both of the historical circumstances of the issuer, as well as current data – is fundamental to making reasonable estimates of future returns. But for those willing to make the effort, the rise of the Internet, the consolidation of European financial markets around the turn of the millennium and other social changes make global investing a new avenue for profit.

Corporate or Government. AAA or Junk. Subordinated or unsubordinated. 30 year or 3 month. The list goes on.

Classifying and tracking the different types of bonds is a full-time job for many. Ok, maybe not everyone’s idea of an exciting career, but necessary and extremely helpful to the investor.

ISSUER and RISK

One way to divide bond types is by issuer. The practice isn’t trivial, since it guides the investor in making decisions about risk, yield and tax liability.

Bonds range from U.S. Treasury (or Euro) bonds, bills or notes (the terms refer to different maturities – the number of years before the principal is repaid), considered among the lowest risk, down to corporate junk bonds or worse.

Risk and yield (total return over time, in percentage terms) tend to be correlated. That is, a low risk bond tends to yield a low return (say 3%). Junk bonds have some of the highest yields, but are some of the riskiest since the chance of default on the principal is high. If the business fails, even though bondholders get priority on assets, position in line is unimportant if there’s nothing to hand out.

When a company does default with salable assets, priority comes into play. When assets are liquidated, unsubordinated (senior) security holders are paid before subordinated, who are paid before shareholders (owners of stock). Hence, bonds carry classifications of Subordinated or Unsubordinated – something to consider when making estimates of risk.

MATURITY and YIELDS

Bonds can be categorized by Maturity – the length of time from issuance to repayment of principal. Periods range from 3-month to 30-year, with 6-month, 2-year, 3-year, 5-year and 10-year also standard. Corporates tend to be on the shorter end of the scale.

The existence of different periods entails the need to consider: (1) How long to invest capital vs the desire or need to sell prior to maturity date – which implies the possiblity of selling at a loss, (2) calculation of total yield vs what could be obtained from another investment.

Calculating yield is a bit complex for the average investor, but fortunately utilities to perform it are readily available on the Internet. For those interested in the mathematics the formula is:

c(1 + r)-1 + c(1 + r)-2 + . . . + c(1 + r)-n + B(1 + r)-n = P
where
c = annual coupon payment (in dollars, not a percentage)
n = number of years until maturity
B = par value (original issue price)
P = purchase price

Suppose a bond is selling for $950, and has a coupon rate of 7%, it matures in 4 years, and the par value (original issue price or face value) is $1000. What’s the YTM, Yield To Maturity? The coupon payment is $70 (that’s 7% of $1000), so the equation is:

70(1 + r)-1 + 70(1 + r)-2 + 70(1 + r)-3 + 70(1 + r)-4 + 1000(1 + r)-4 = 950.

Using one such caculator: r = 8.53% which is the Yield. You can observe it’s higher than the rate.

PREDICTABILITY

The details are complicated, but the lesson is simple and to the investor’s advantage. Since bonds have fixed characteristics their risks and returns are much more readily predictable with confidence. No investment is certain, but bonds have attractive features not shared by other choices. Every portfolio should have some.