RateWatch #345 - The Bond Market
March 1, 2003 By Dick Lepre
The Bond Market
Often we talk about "the bond market." The StoMaster Rate Forecast www.stomaster.com is a sophisticated method of analyzing the movement of bond prices.
It might be a good idea to take a look at what the bond market is, what makes it move, what some of the jargon is and how the bond market affects mortgage rates. Please appreciate that this is a complex topic which we are dealing with in a manner to cast some light on why and how it
affects mortgage rates.
Bonds are the main way that municipal agencies and corporations borrow money. When we talk about the "bond market" we are restricting our discussion to the issues of the United States Treasury Department. The government, for a reason that I have never quite understood, spends a lot more money than it takes it. It makes up the difference by selling bonds which then constitute short and long-term debt.
The Treasury Department borrows with maturities of 3 and 6 months and 1, 2, 3, 5, 10 and 30 years. The short term ones (1 year or less maturity) are called "Bills" the 2-10 year versions are called "Notes" and the 30 year is called a "Bond." Bonds are auctioned. Before the auction, a "coupon" rate is set. When the auctions occur there are 2 types of bids: competitive and noncompetitive. Most individual investors purchase Treasury Securities by submitting a non-competitive bid. By placing a noncompetitive bid, you are guaranteed average yield and equivalent price determined at the "competitive" auction. Competitive bidding is generally done by large financial institutions and brokers who are familiar with the securities market. As a competitive bidder, you must submit a sealed bid specifying the rate you are willing to accept. This is specified out to 3 decimal places. All noncompetitive bids will be accepted for that auction. The remaining balance of the offering is allocated among competitive bidders, beginning with the lowest yield until the total amount needed is satisfied.
So Then What?
These notes and bonds are usually purchased by brokers who then retail them. Once they are
distributed, the fun begins. One thing to appreciate is the scale of this thing. On 9/1/2002 the total public debt (Federal and local) was $6,228,200,000,000. That is, $6.2 trillion dollars.
Investors then buy and sell these bonds on a cash market. When you see on-line price quotations
there are 3 figures: "bid" (what someone is offering to pay), "ask" (what someone is offering to sell) and "strike" (what the last transaction actually took place at).
For example, the 30 year bond issued 2/15/01 has a "coupon" of 5.375%. If it closes trading at 110 19/32 bid, then for every $1,000 of bonds someone was offering $1,106. Divide the 5.373% face by 1.106 and you get 4.86% yield. So, the bond yield would be 4.86%. Note that this is why the price and the yield move in opposite directions. When the price (the divisor), moves up and the quotient (the yield) moves down.
Futures vs. Cash
The StoMaster Rate forecast deals not with cash purchases of bonds but with bond futures. Cash and futures prices move in virtual lockstep.
The Federal Reserve
Currently, one of the strongest tools that the Federal Reserve has in regulating the economy is buying and selling Federal debt on the open market. That's what the FOMC (Federal Open Market Committee) is all about. It sets the target. Clinton suggested that, in order to bolster the Social Security system, the Fed seek to invest a chunk of money in equities. Whatever may
be good or bad about this, it certainly upset Greenspan. The problem is that this would necessitate the Fed giving up some of its control over interest rates to others because "others" would now hold a larger share of the public debt because the Fed is playing the equities market.
Why Does This Thing Move Around So Much?
Bond prices go up only for one reason: because there are more buyers than sellers. Similarly, they go down because there are more sellers than buyers. But, every day, thousands of people need to explain why the imbalance is occurring. Since the bonds have a fixed coupon rate, their value moves significantly according to the perception of inflation. If there were no inflation at all, the value of a 30 year term 6.625% bond backed by the United States Treasury department would be very large. If inflation is, say, 5% the value would be much smaller. Thus, every little bit of economic news is analyzed to see how it affects the overall picture of what inflation is
and what it is going to be. The sick thing about this is that we folks who are hoping for lower interest rates are like the undertaker in one of those Clint Eastwood Westerns. When bad news comes to town our business picks up. Conversely, good economic news is bad news for rates. On March 8, 1996 the Bureau of Labor Statistics announced that non-farm payrolls were up 705,000. The price of the 30 year bond fell more that 3 points and interest rates went up 0.25%.
Bond prices have, in recent years, proved to be quite volatile. Some issues have lost nearly 15% of their value within a year.
The problem with the volatility of the 30 year bond is that it is the basis for all other interest rates.
The interest rate on a 30 year, fixed rate conforming loan is going to be around 1.125-1.5% higher than the bond yield. When the bond yield goes up the yield on Mortgage Backed Securities goes up and fixed rates go up.
The Yield Curve
Usually longer maturates provide higher yields. The "shape" of the yield curve is always changing. At a time when there is a small difference between the yield of 10 year and 30 year issues it makes no sense to incur the greater price risk of the long issue for a tiny increase in yield. Sometimes the longer issue yields enough more than the intermediate term issue that it may justify the increased price risk that goes along with it. Sometimes, the yield curve itself reveals potential risk. When it is "inverted" (when short term yields are actually higher than long term)it is telling you that the "market" expects a decrease in rates. When steeply positive (yielding much more in the long end
than in the shortend) it is telling you that the market expects rising rates in the future. Recessions are almost always preceded by an inverted, or at least flat, yield curve. One detail to appreciate is that, whereas we are always talking about the 30-year bond, it is the yield on the 10-year note that most accurately predicts the movement of mortgage rates. The 30-year bond yield is like the Dow Jones Industrial Average. It may not be the best indication of what's happening but it is what everyone is talking about.
At times when the Federal Reserve is moving the Fed Funds rate up or down the effect will be seen more on the shorter duration Treasuries than on the long end. Practically speaking, the Fed controls the short end but the market controls the long end.