Investor 007's Bond Dossier

Meet Investor 007. His specialty? Bonds. Fixed-income bonds.

Don't be fooled by their low-profile reputation. Beneath that cunning disguise, bonds are sophisticated tools to help safeguard your portfolio from the perils of riskier investments. Here's the latest intelligence on their high-stakes world. If you're new to the game, get briefed on the basics of Investor 007's business, or check out our Bond Center for some useful gadgets to help ensure a successful investing mission.

Spying on rates
The benchmark U.S. Treasuries are key rates to keep under surveillance. Corporate issues are generally priced at a spread to a Treasury rate with a similar term, based on the issuer's credit rating.

Clues to the market
The broad credit market is influenced by a host of macroeconomic factors. Last week, bonds felt pain induced by further evidence of a soft economic landing. For the week, the 10-year yield increased 12 basis points. Bond prices move inversely to yields.

Treasuries slipped in light trading on Monday, during a session in which Federal Reserve Vice Chairman Donald Kohn gave a dovish outlook on the economy, when he commented on growth and receding inflation. The two-year yield tacked on three basis points to 4.78%, and the 10-year yield added two basis points to yield 4.66%. Prices remained little changed on Tuesday. Rising mortgage applications and a narrowing trade deficit, together with comments from Chicago Fed President Michael Moskow warning that policymakers retain vigilance against inflation, sent Treasuries lower on Wednesday. The two-year yield increased two basis points to 4.80%, and the 10-year rose three basis points to 4.69%.

Leave it to the Brits to further spook the bond market. On Thursday, an unexpected move by the Bank of England to raise its benchmark rate caused Treasuries to fall and provoked fears of further increases by other central banks. Yields on both the two-year and 10-year notes picked up five basis points to yield 4.85% and 4.74%, respectively. On Friday, in a shortened trading session ahead of the holiday weekend, a robust December retail sales report further damaged Treasuries. Ten-year notes fell for the sixth consecutive day, picking up three basis points to yield 4.77%, their highest yield since late October.

Detecting developments
Investor 007 noted the following occurrences in the bond market last week:

• Aramark (NYSE:RMK) is reportedly seeking to take advantage of the current issuer-friendly environment by financing its leveraged buyout of concession-stand operators in sports arenas through a $3.66 billion loan without restrictive covenants such as quarterly debt to cash flow ratios.
  
• Three banks, including Bank of New York (NYSE:BK), Wilmington Trust (NYSE:WL), and a unit of Deutsche Bank (NYSE:DB), paid a total of $1.6 million to settle charges by the SEC that they engaged in improper activities in auction rate bond sales.
  
• A group of bondholders of Adelphia challenged the valuation of Time Warner Cable shares under the company's $15 billion restructuring plan. A hearing is scheduled for today, and the plan is scheduled to become effective on Wednesday, barring further legal stays.
  
• The Treasury auctioned $9 billion of 10-year TIPS on Thursday to weak demand at a higher-than-expected yield of 2.449%.

Hot tip
Last week's hot tip concerned selection of the appropriate benchmark for your fixed-income assets. In that discussion, we described the characteristics of certain indices, including their average durations. Before too much time rushes past, let's make sure that concept is understood.

Duration is one of those high-finance words that investors may overlook or even consciously ignore for fear of its supposed complexity. Actually, the concept is both simple to understand and important. Duration is the most common quantitative measurement of bond risk. Various funky ways exist to calculate it, incorporating a bond's coupon, yield, maturity, and call features, but generally, the term is meant to indicate, in terms of years, how price-sensitive a bond is to changes in interest rates.

Effective duration, the most common expression, signifies the approximate percentage change in price for a 100-basis-point change in yield. So the price of a bond with an effective duration of six years will rise (or fall) 6% for every 1% decrease (or increase) in yield. The more sensitive a bond is to changes in interest rates, the longer its duration and the riskier its potential behavior.

As long as you're familiar with this concept, duration will endure as a valuable analytical tool for your bond portfolio.

Time Warner, the parent company of Time Warner Cable, is a Motley Fool Stock Advisor recommendation. And for more on bonds, make sure to check out the Fool's Bond Center.

Fool contributor S.J. Caplan has been an undercover fixed income aficionado ever since serving in banking and legal capacities covering debt underwriting as well as fixed income derivatives. She owns U.S. Treasuries and shares of the Fidelity Inflation Protected Bond Fund. She prefers her portfolio shaken, not stirred. The Fool has a disclosure policy.