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I'll let myself being used as an economic student / guinea pig... But only for this post, because I'm poised to leave.

Bloody linguistic terms. It's still rather opaque to me - One buys to realise a profit? I do see how the principle works, yet when does the actual return set in? When do you "sell" bonds to realise the profit in actual numbers on your bank account? Or is the buying the selling? *confused *

And (once again): (how) does the bond market affect the stock market?

by Nomad on Tue Jun 19th, 2007 at 11:39:23 AM EST
[ Parent ]
If you buy a 10-year €1,000 bond for €600 when the bond is issued, you invest €600 now and are guaranteed €1,000 10 years from now. If you lend €600 at 5.24% annual yield and only require one repayment 10 years from now, the borrower will have to pay you €1,000 when the loan expires. So buying a bond is like lending money, and if the yield is positive (or larger than inflation, or larger than the profit you can make elsewhere, or larger than whatever your benchmark is) you'll make a profit.

Of course, if you can turn around a year later and sell the bond for €660 then you've made a 10% in a year, the yield of thebond has gone down to 4.72% and the price went up higher than expected.

The bond market affects the stock market in that bonds involve guaranteed payments so, neglecting default risk (and if the bond is a US treasury bond you pretty much can) the bond yield is a measure of risk-free return. When valuing stocks, return is measured relative to the risk-free rate of return. So, if bond yields go down, stock returns above the risk-free rate go up and so investing in the stock market becomes more attractive. Also, investments that used to be less profitable than bonds and so wouldn't be undertaken suddenly become profitable.

Can the last politician to go out the revolving door please turn the lights off?

by Migeru (migeru at eurotrib dot com) on Tue Jun 19th, 2007 at 11:57:33 AM EST
[ Parent ]
Migeru:
If you buy a 10-year €1,000 bond for €600 when the bond is issued, you invest €600 now and are guaranteed €1,000 10 years from now. If you lend €600 at 5.24% annual yield and only require one repayment 10 years from now, the borrower will have to pay you €1,000 when the loan expires. So buying a bond is like lending money, and if the yield is positive (or larger than inflation, or larger than the profit you can make elsewhere, or larger than whatever your benchmark is) you'll make a profit.

That makes it crystal clear what a bond is for the ignoramus.

Similarly:

the bond yield is a measure of risk-free return. When valuing stocks, return is measured relative to the risk-free rate of return. So, if bond yields go down, stock returns above the risk-free rate go up and so investing in the stock market becomes more attractive. Also, investments that used to be less profitable than bonds and so wouldn't be undertaken suddenly become profitable.

This explains to me the relation between the bond and stock market. And I haven't been looking up information since I logged off yesterday.

If J could blend this into his diary as an introduction to the bond market, I think it would be able to reach a larger audience unfamiliar with financials.

by Nomad on Wed Jun 20th, 2007 at 03:30:02 AM EST
[ Parent ]
I think the concept of the Anglo Diseasa is important enough to warrant writing some concise explanation of these underlying concepts. I'll do that in the very near future.

In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Wed Jun 20th, 2007 at 04:30:19 AM EST
[ Parent ]
The relation between stocks returns and yields is incomprehensibly "explained" in the wikipedia article on the Sharpe Ratio.

Maybe the article on Modern Portfolio Theory will be more instructive, but I think it's overkill - more than you need to know about any of this. However, this diagram from the article hopefully makes it clear what "excess return above risk-free" means.

Can the last politician to go out the revolving door please turn the lights off?

by Migeru (migeru at eurotrib dot com) on Wed Jun 20th, 2007 at 05:52:04 AM EST
[ Parent ]
This quotation from the diary
Describing the interest rates set by the bond market as the "cornerstone" for valuing equities and other securities, [Albert Edwards, Dresdner Kleinwort's well-known global equity strategist] cautions that if the bond market has truly entered a new era of steadily rising long-term rates, "all investment portfolios will be shredded to ribbons".
might be clarified by this other quotation from the beginning of the FT piece:
US Treasury bond yields in effect set the "risk-free" rate used when pricing securities - from corporate credit through derivative contracts to equities - across the world. They form the financial world's clearest expression of risk.
Does this answer "how the bond market affects the stock market"?

Can the last politician to go out the revolving door please turn the lights off?
by Migeru (migeru at eurotrib dot com) on Tue Jun 19th, 2007 at 12:15:54 PM EST
[ Parent ]

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