How Bonds And Bond Futures Are Priced

Given the length of the current bull market and the outperformance of stocks over the last nine years, it’s not out of the realm of possibility to suspect that many newer traders don’t have much exposure to the fixed income markets. Those with only a passing familiarity with how bond prices work are likely hazy on how the treasury markets are actually priced.

At their most basic, treasury notes and government bonds are debt investments that have regular coupon payments to their holder over a fixed interval with a fixed interest rate.

While that might make it seem like their value is set in stone, the fact that bonds and notes have a fixed interval and a particular interest rate at which they’re repaid means that their value is relative to the prevailing interest rates at the time. If a $1,000 treasury note is paying interest at 6 percent, it’s going to be more valuable than one that is repaying at 3 percent. This is why bond prices and interest rates are negatively correlated.

Another result of this relationship is that treasury futures contracts are often used as way for traders to anticipate either a rise or fall in interest rates. This is why the recent interventions and hawkish signals from the federal reserve have driven bond prices down while yields have risen. Yields represent the nominal value of a bond’s payments in the current bond market, as bond prices go down, bond holders can reinvest their yield at a lower cost, and vice versa.

Investors who trade bond futures, including two- five- 10- and 30-year bonds, pay close attention to commentary from members of the Federal Reserve’s Federal Open Market Committee. Having an indication of where interest rates are headed is critical to forming a thesis on the possible direction of bond prices. Just look at what the 10-year treasury futures and 30-year-bond futures did on Wednesday when the Fed raised interest rates 0.25 percent, for example.

However, it is not the only indicator they use. Economic data like Gross Domestic Product, Non-farm payrolls and the Consumer Price Index often reveal exactly the type of inflationary information that the Fed governors use to set interest rate targets in the first place.

While current signals from the Fed have prompted a downtrend in bond prices, the value of popularly traded treasury futures like the 10-year note, which often serves as the benchmark indicator for economic resilience, can be a good thing to remain aware of for any type of trader.