7 Cool Things Bonds Tell You About the Economy

Bonds are often cast as the boring stepchild of investments, but they can actually offer some great insights into the machinations of our economy. Their yields and interest rates that are affected by overall economic conditions, so you can learn a lot by owning them. And they may even predict how certain aspects of the economy will evolve. (See also: 5 Crucial Things You Should Know About Bonds)

Here are seven things that bonds can tell us.

1. They Can Tell You If the Economy Is Healthy (or Not)

Some bonds perform well when the overall economy is in good shape. Others perform better when times are tough. High-yield bonds, emerging market bonds, and corporate bonds with low ratings tend to perform best when the economy is strong. But U.S. Treasuries — which are seen as less risky — don't perform as well when the economy is doing well.

So, if you want to get a general sense of how the national or world economy is doing, pay attention to the types of bonds people are investing in. Generally speaking, a rush to riskier bonds means things are going well. But when times are tough, Treasuries are often the place investors flock to. Here's a helpful chart that shows how different bonds perform in various economic conditions.

2. They Can Predict a Recession

In the 1980s, economists began to realize that they could predict economic activity by looking at something called the bond "yield curve." In simple terms, this is the difference in the interest rates between three-month and 10-year Treasury notes. If the interest rates on 10-year notes are higher than the shorter-term rates, then the chances of a recession in the next 18 months are not very high, according to information published by the Federal Reserve. When the yield curve is inverted — meaning long-term interest rates are lower — then look out. This was the case in 2006, and America was in a recession within two years.

3. They Can Predict If You'll Pay More for Stuff

One of the downsides to investing in Treasury bonds is that they can lose value due to inflation. That's why the government introduced something called Treasury Inflation Protected Securities (TIPS). These are like bonds, in that they have a fixed-rate yield and regular interest payments, but the principal is adjusted according to the Consumer Price Index.

Generally speaking, you can determine the possible rate of future inflation by examining the spread between the yield in a bond and a TIPS with a similar maturity date. So for instance, if a three-year Treasury note has a yield of 4% and a three-year TIPS note has a yield of 2%, then the expected rate of inflation over the next two years is 2%. This is not an exact science, however, as there are a multitude of factors that can drive inflation.

4. They Can Tell You If Stock Investors Are Skittish

When investors flock to bonds, it's often because they are feeling less confident about riskier investments, such as stocks. Bonds are popular investments among those close to retirement, but when all investors are drawn to bonds, it could be a sign that the stock market has taken a dive or is underperforming. Conversely, less interest in bonds could be a sign that the stock market is doing well.

5. They Can Tell You If Companies Are Investing in Themselves

Corporate bonds can give you a glimpse of what companies are doing with their money, especially whether they are looking to expand. Even large companies with a lot of cash will issue bonds in order to make big capital improvements, fund an acquisition, or invest in research and development. (Even Apple, which reported $55 billion in cash in the last quarter, also reported $10 billion in bond debt.)

Be careful, however, as many companies go into debt simply to stay afloat. Pay attention to the ratings on corporate bonds to get a better understanding of how companies may be using debt. A company with a strong credit rating is more likely to be raising funds for investment or expansion rather than to simply fund operations.

6. They Can Impact What You Might Pay for Your House

The government does not set mortgage rates. Banks do that. But banks will often keep mortgage rates in line with those of long-term Treasury notes. That's because Treasuries and mortgages are offered for similar terms, usually in the 10- to 30-year time frame. So when Treasury notes rise, mortgage rates usually rise, as well.

7. They Can Let You Know if Your City Is in Trouble

Municipal bonds can offer insight into the economies of cities and states. Municipalities will sell bonds in order to raise money for capital projects. The size and quality of these bonds are clues into whether a city is investing properly or has too much debt. Bonds with high interest rates may come from cities with less-than-stellar credit — a sign of a city that has been struggling. (For an example, take a look at Atlantic City, which is struggling to make debt payments after years of declining tax revenue.) Moreover, bonds will tell you whether a municipality is selling bonds just to fund normal operations, or for investments in things like infrastructure that will benefit the city's financial health over the long term.

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