Why Bonds Matter

Most people are familiar with savings bonds, where you can purchase a certain amount and then receive interest in the form of a coupon — usually as one lump payment when the bond matures. A 10-year savings bond, for instance, will pay the face value of the bond, plus the interest rate on the coupon.

Securities issued by the U.S. Treasury work much the same way. A 30-year bond, for instance, might have a face value of $1,000 with a coupon of 8 percent. But that bond won't pay out its full value for 30 years. It is investors betting on what they think will happen in those 30 years that helps determine what the price, coupon and so-called yield — interest rate, in layman's terms — a bond will pay.

The higher the price of a bond is, the lower its yield — or interest rate — is, because investors are betting that the value of the bond and the interest it pays will outpace inflation when it matures.

Which is why bond investors watch the progress of the economy so closely, particularly the pace of consumer prices. The idea is, if $1000 now will buy you a certain amount of goods or services, you want to make sure that the $1000 plus interest is going to buy the same amount of goods and services in the future, especially if its locked in.

Investors bet on whether or not it will, which determines the market value of the bond and helps explain why something that supposedly has a set value moves in price. A bond is more valuable if its total value at maturity will buy more.

That helps explain why bond investors love bad news. Unlike stocks, which thrive on expectations of a strong economy, bonds prefer slower economic growth. You see, the slower the economy is, the less chance of inflation rising, eroding the fixed value of the securities. High unemployment, poor consumer confidence and lackluster spending are all music to bond investors' ears.

As for the Treasury's decision last week, the effect will be similar to another interest-rate cut from the Federal Reserve. That's because bonds across the board - from short-term, 3-month securities all the way out to the now-dormant 30-year Treasury, declined, forcing banks and other lenders to lower the rate they charge consumers and businesses for mortgages and certain types of loans.

"At the end of the day it's Uncle Sam effectively trying to reduce long-term interest rates," said Paul McCulley, a managing director on the investment committee of Pacific Investment Management Co., which oversees about $220 billion in assets from Newport Beach, Calif.