EDMOND — Political consultant James Carville once said, “I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.” Of course, what he meant was that bond prices and yields ultimately have a major influence on economic activity.

In case you had not noticed, the stock market has been a little volatile lately. Wow! Is that an understatement? We’ve had so many triple-digit price moves lately that when the Dow is only up or down 50 points it’s almost boring. But while the stock market gets all the headlines, you may not know that the bond market, which some think is slow and boring, has been quite volatile also. Let’s take a look.

But first, for those who may not be as familiar, let’s make sure we understand the basics of bonds. Bonds are a form of debt. When a company or a government needs to borrow money it can borrow from banks and pay interest on the loan, or it can borrow from investors by issuing bonds and pay interest on the bonds.

When borrowing from a bank, the bank usually will require payments on the principal of the loan in addition to the interest, so that the loan gradually gets paid off. Bonds, on the other hand, allow the borrower to only pay the interest while having the use of the entire amount of the loan until the bond matures in perhaps 10, 20 or 30 years when the entire amount must be paid off.

Two main factors determine the interest rate 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 buy the offering. If demand is low, they will have to pay higher yields to attract investors. The other influence on yields is credit risk. Just as an individual with a poor credit score has to pay a higher interest rate on a loan, so a company or government that is a poor credit risk has to pay a higher interest rate on its bonds in order to entice investors to buy them.

Surveys show that one factor many investors do not understand is that bond prices move opposite to their yields. That is, when yields go up the price of bonds in the open market declines and the opposite happens when yields go down. Try to envision a child’s teeter totter. One end is yield (interest rate) and the other end is price. As one end moves up or down, the other end does the opposite.

Why is that? Consider an investor owning a 30-year bond bought several years ago when bonds were paying 6 percent. He wants to sell the bond rather than hold it to maturity. But what if yields on new similar bonds have fallen to 3 percent? Investors have to pay considerably more for his 6 percent bond than for a new bond paying only 3 percent. So as yields for new bonds decline the prices of existing bonds go up. In the other direction, bonds bought when their yields are low will see their value in the market decline if yields begin to rise, because investors will pay less for them than for the new bonds that will give them a higher yield.

Prices of U.S. Treasury bonds have been particularly volatile the past three years. Demand for them as a safe haven has surged in periods when the stock market declined, or when the eurozone debt crisis periodically moved back into the headlines. Conversely, demand for bonds has dropped in periods when the stock market was in rally mode, or when it appeared that the eurozone debt crisis had been kicked down the road by new efforts to bring it under control.

Meanwhile, in the background the U.S. Federal Reserve has affected bond yields and prices with its quantitative easing (QE1, 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 as the stock market, if not more. For something considered slow and boring, it has been pretty wild.

For instance, just since mid-2008, prices of 20-year U.S. Treasury bonds have experienced four rallies in which they gained as much as 40 percent. The smallest rally produced a gain of 13 percent. But they were not “buy and hold” type situations. Each rally lasted only from four to eight months, and then the gains were completely taken away in corrections in which bond prices plunged back to their previous lows.

Most recently, the decline in the stock market during the summer months, followed by the re-appearance of the Eurozone debt crisis, has had demand for U.S. Treasury bonds soaring again as a safe haven. The result is that bond prices are again spiked up to overbought levels, and yields dropped to record levels, where they are at high risk again of a serious correction.

Bond yields are at historic low levels with little room to move lower. (Remember our teeter totter analogy?) When will the bond price reversal start again? Beats me. But logic would tell you that bond yields are not going to zero and the likelihood of yields going much lower is pretty small. If you have long-term bonds that you need to liquidate to raise cash in the next year, you may want to consider the price risk you may be taking and make adjustments soon. That could mean selling some and shorten average maturities, or even hedging part of the bond portfolio. Whatever you do, be aware of what you own. As Carville noted, bonds can do a lot of intimidating. Thanks for reading.



NICK MASSEY is a financial adviser and owner of Householder Group Financial Advisors in Edmond. Massey can be reached at www.nickmassey.com. Securities offered through Securities Service Network Inc., member FINRA/SIPC.