Competition for Capital Investment

• Bonds and stocks compete daily for capital. Bond issuers always look to minimize their issuing costs, while raising enough capital for their intended projects. For risky projects, investors look to receive ownership stakes through stock to compensate for risk. Bond buyers seek capital safety by foregoing the unlimited upside of an equity position and demanding strong asset protection for their investment and interest payments. Bond investors demand real rates of return above the risk of inflation and credit.
  
  

Bond Valuations and the Yield Curve

• Bond valuations are a function of total return. Total return is income and capital gains. Bond investors incur valuation losses when interest rates rise because prices on existing, lower yielding, bonds must drop to compensate for the higher yields available. Investors will curtail or lower their bond purchases while awaiting higher yields. They buy shorter maturity bonds that are not as adversely affected by price fluctuation. The result is that relative yields of bonds by maturity, called the yield curve, steepens.
  
  

Bond Valuations and Alternative Investments

• Bonds are a source of liquidity because bond valuations do not vary as much as stocks or alternative investments, such as private capital or commodities. Bonds are not subject to long periods of investment without receiving cash interest payments. The ability to quickly sell bonds for alternative investments increases bond valuations. The liquidity preference is often challenged during low interest rate periods as investors are emboldened to increase total return by increasing risk. Low interest rates promote the use of noninterest bearing commodities and real estate development.
  
  

Bond Valuations are a Function of Credit Quality

• Strong companies with high credit ratings pay low interest rates for their bond issues compared to lesser quality credits. This is a function of their superior debt coverage, or ability to service interest and principal. This difference between strong and weak credits is called the credit spread. The higher the credit spread, the greater the difference in yields. During economic cycles, credit spreads will vary greatly. Spreads narrow during good economic times as all companies have improved debt coverage. During economic hardship spreads widen, reflecting the increased risk of default or late payment.