Understanding Bonds: Prices vs Yield

A bond represents nothing more than a stream of income: regular coupon payments and then the principal payment at bond maturity. For example, a $100,000 30-year Treasury Bond having coupon 6% would pay to the holder interest income of $6,000 every year and then $100,000 at maturity in 30 years. Treasury Bonds are backed by the financial credibility of the U.S. government who guarantees that payments will be made. Treasury Notes are similar but have a shorter maturity than bonds, usually 10 years or less.

Bonds are quoted in terms of $100 of face value. In the example above, if this Treasury Bond were trading exactly at 100, then a buyer would receive 6% annually for 30 years. However, it is often the case that buyers demand a different rate of return. If investors desire a higher rate of return, then the price of this Treasury Bond will trade at a price below 100, for example, at 97. This has the effect of driving up the implied rate of return, also called the yield to maturity, to a value of say, 6.20% The bond's price will continue to fall, and the yield to maturity will continue to rise, until investors are content to buy the bond. On the other hand, if the bond's coupon seems very attractive, then investors may bid up the price of the bond say to 103. This will lower the yield to maturity to say, 5.80% and subsequently reduce the demand for the bond.

In practice, it is rare that a bond trade exactly at par, that is, exactly at 100. This is because the rate of return that investors demand often changes especially in response to new information on the economy. Falling bond prices mean that interest rates corresponding to that bond are rising while rising bond prices mean that interest rates are falling. In other words, bond prices and interest rates move in opposite directions.

Trading U.S. Treasury Bonds & Notes

While U.S. Treasury Bonds and shorter-dated Treasury Notes for that matter do trade in a cash secondary market, it is the futures market that provides access to these assets for most investors. CME Group (which includes the former CBOT) is the regulated exchange on which futures and options contracts on Treasury Bonds and other U.S. Government securities are traded. Treasury Notes of 10-year duration are the most liquid and are generally perceived as the benchmark. See Trading Volumes - Select Treasuries at right. According to data from CME Group, about 98% of the trading volume done in interest rate futures in 2011 was executed across the exchange's electronic trade matching platform as opposed to open outcry. Options on these futures, in contrast, still relied on open outcry with about 82% of the total volume being executed as such in 2011.

U.S. Treasury Bond prices are influenced by domestic economic data such as employment, income growth, and overall consumer and industrial prices. Any data which supports expectations of rising inflation tends to weaken Treasury Bond prices because inflation erodes the present value of the stream of income that the bond provides. You will almost always see the bond market drop during a time of heightened inflationary concerns.

U.S. Treasury Bonds are also viewed as a safe-haven investment. Consequently, they often rally during times of international financial crises. Investors, both domestically and internationally, value the credit guarantee of the U.S. government and this gives U.S. Treasury Bonds and Notes great appeal when the credit quality of other borrowers - including other governments - falters. This has been the predominant reason for the incredible rally in Treasury debt prices in late 2008 and early 2009. More recently, U.S. Treasury securities have enjoyed another flight-to-quality in response to growing concerns over high government debt in many European countries.

Many investors believe that it is only a matter of time before the debt situation of the United States comes into the spotlight at which time U.S. Treasury Bonds and Notes may be sold heavily. Moreover, some investors are also speculating that global inflation may soon become a problem which would also lead to bond selling in general. Indeed, some nations like China are already seeing unexpectedly high rates of inflation. Among other nations, inflation could be sparked not by domestic growth but rather by their government's printing excess money to pay debt servicing costs. These investors can find an easy trade in the futures and options market for U.S. Treasury Bonds: sell a futures or buy a put option or bear put option spread.

Since trading bonds means trading Treasury Bond or Treasury Note futures and options, the beginner should start with a basic overview of the futures and options (on futures) markets. Futures trading is not appropriate for everyone so it's important to first decide if this type of trading is appropriate for you. You may want to watch our free series of Futures Trading Videos. In the comfort of your own home, you'll have over one hour of lectures covering 8 introductory topics on futures trading all narrated by the President of World Link Futures. Tailored for the beginning futures trader, you'll learn the futures market basics such as how to read a bar chart and common order types, how to calculate profit and loss on a futures trade, how margin works and tips on risk management. You'll even see how to perform a regulatory background check on a futures broker or other industry participant.

Buying options on Treasury Bond or Treasury Note futures let you trade a price prediction (or interest rate prediction) in a way that can be much less risky than trading the corresponding futures. Our site How to Buy Options will give you a comprehensive education in buying calls, puts and option spreads.

Trading bonds should not be done impulsively but rather, it must follow the rules of a well-defined trading system. A trading system specifies when to get into a trade, either long or short, and when to close a trade, either at a profit or at a loss. (For a general discussion of trading systems, request our free brochure, How to Invest.) Developing a bond trading system from scratch is a considerable undertaking. Alternatively, you can buy or lease a trading system that has already been developed and tested. We recommend the long-term bond trading systems from Advanced Trading Systems, Inc. The ATS-3200 system trades long-term Treasury Bonds and the ATS-6400 trades 10-year Treasury Notes. Each system generates clear buy and sell signals, is easy to use, requires little time to implement and is completely objective. Read more and request a free 30-day trial of these bond trading systems.

Do you have your own idea for a bond trading system? Maybe you’ve spotted a pattern in price activity. It could be a day-of-the-week effect, a time-of-the-day effect, or a new relationship with other, related markets. Many of us have ideas but have been stopped short by the daunting task of translating that idea into a trading system and then properly testing that system. While many trading platforms such as NinjaTrader, MetaTrader and AIQ have become fairly sophisticated in their application for system design and testing, it seems that a trader needs to be part programmer in order to take full advantage of them - and many of us are not. Our custom trade system programmer can help. He has coding and programming experience with all of the major trading platforms and is even a trader himself. He can translate your idea into a trading system and then test it. The result may be a fully automated, personalized bond trading system that generates investment income for years to come.

Have a question about trading bond futures and options? Then speak to a futures trading professional. They'll help you decide if trading futures is right for you. Go ahead and Talk to a Futures Professional in the box above.

Finally, before you trade bond futures and/or options with hard-earned dollars, we recommend that you start by paper trading. This futures and options simulated trading account is free and a useful educational tool especially for the beginning futures trader. The professionals at The Futures Training Division of PFGBEST who provide this futures and options paper trading account are not only willing to spend the time in helping the beginning futures trader, but they can also help you set up a real account when you're ready, making the transition to actual futures trading easy and stress-free for you. If you have trading experience, you may prefer instead to practice in an online futures demo account.

While this web site was designed to be accessible to all, especially the beginning futures trader, that is not to say that futures trading is appropriate for everyone. As with any type of investment, it should be carefully considered along with your personal tolerance for risk and available risk capital. This web site will help you make an informed decision.

Recommended Reading...