If asked, "What is the single most important financial vehicle in the monetary realm?", what would your answer be? The automatic response of countless multitudes would be "Why the stock market, of course!" And their answer would not be too far from the mark. But there is an answer to this question that is even more accurate that few investors are aware of: it is known as the bond market.

While nearly everyone possess a working knowledge of the bond market and its terms, few really and truly understand the underlying concepts that make a bond market work. All are familiar, for instance, with terms relative to the bond market such as "interest rate" and "yield." But how many truly comprehend the connection between interest rates and yields and the money supply? How many perceive the importance of a bond market to our entire financial system (including its importance to the stock market), as well as our overall economy? How many can even explain in succinct terms what the bond market is all about? In an effort at alleviating this all-too-common malady, we will attempt to explain herein the meaning of the bond market, its importance and its message.

What exactly is a bond market? Perhaps this question can best be answered by explaining what a bond market isn't. Buying a bond is not the equivalent of buying a stock in a company. Purchasing stock is, in effect, purchasing a piece of ownership in a particular company. By buying shares of a company's stock you are entitled to a certificate of ownership which declares you to be the owner of so many shares in that company, in short, that you possess an interest in that company's management and profitability. You may choose to buy and sell that securitized interest in that company by selling it in the stock market through a licensed broker. Your certificate of shareholdership may appreciate or depreciate in value, and sometimes it may even be "called" (depending on what type of transaction you have entered to buy the stock). But all it ultimately means is that you supposedly have a stake in the company you have invested in. You don't actually own anything other than the piece of paper.

Purchasing a company's bond, however, is a bit different. When you buy a securitized corporate bond (of which there are many different types) you are, in essence, buying a piece of that company's debt. You are agreeing to assume payment of that company's financial obligations by lending them your money so that they can make business transactions and (hopefully) produce a profit. The bond holder is helping to finance the company's capital expenditures and maintenance costs, as well as helping them to meet its interest payments to the banks which own their capital. Buy buying a company's bond, you own a legitimate stake in their business—you have something you can hold over their head. In exchange for agreeing to assume its debt, a company will pay interest (i.e., income) to its bondholders, as well as promising to repay the full face value of the bond at maturity. Simply put, a large, capital-intensive company could not hope to long survive without their issuance of bonds through the bond market.

Notice a critical distinction between a bond market (and we are speaking principally of corporate—as opposed to government—bonds for the moment) and a stock market: a company can theoretically survive and continue its day-to-day operations even as its stock is plummeting in value and its stockholders are all rushing to redeem their certificates of ownership. Depending on how much of a cash reserve a company has, and how much it depends upon its stock value for financing its activities, it may even survive a long time without the soundness of its stock. But it cannot survive long when its bondholders decide unanimously to cash in and no longer assume the company's debt. This is an important key to understanding the bond market's importance.

When bond holders, en masse, decide through careful research that the company whose bonds they hold is no longer creditworthy and will likely be unable to amortize its long-term debt or to turn over a profit, they will act on this information by selling their bonds back onto the market. This, in turn, causes a decline in the price of a bond. A company's worst nightmare is to see its debt market collapse. It would rather witness its stock crash in value than to see its bond market deteriorate, for it understands the broader implications of this, namely, that stock buyers tend to be a fickle lot who buy and sell at the drop of a pin and with no more justification for their investment decisions than that they "felt" the stock's price was too high or too low. It is very common for a company that has not turned over a profit to see its stock soar in value; conversely, it frequently happens that a company that is profitable and has a clean balance sheet will witness its stock sink in value or meander sideways at an "oversold" level. Is there any logic to this? Of course not, but that is the nature of the volatile and emotionally-driven stock market.

With the bond market, things are quite different. Rarely has the bond market (at least for high quality corporate debt) been described as "volatile." Bond markets are notorious for their painfully slow, steady movements characterized by relatively little fluctuation. Slow and steady—that's how bonds move. Steady because the people who invest in bonds are as far removed from the ephemeral passions and "irrational exuberance" of stock investors as night is from day. Bond investors are a rational lot. They do not buy because they "feel" a particular issue is priced right. They buy only after exhaustive research into a company's history and outlook. They buy bonds only after they are certain their investment will pay off in the long run. When they become net sellers of a company's bond, it is only because they have carefully decided the outlook is not so good—the future looks bleak to them and so they sell. Thus, observing trends in the corporate bond market offer a far more reliable indicator of the corporate outlook than does the volatile stock market.

Who is a bond investor? Is it the taxi cab driver or the shoeshine boy? The average American living on Main Street? No, it is the wealthy class who understand the workings of the market and the true value of money. It is the institutional investor who wants only the highest-rated financial instruments for his portfolio. It is the man or woman of vision who knows truly where the power lies: in holding control of a company through ownership of its debt.

Two of the most famous and successful stock investors of the last century were Jesse Livermore and Richard Wyckoff. Both were noted for their wildly profitable market operations as well as their ability to "read the tape." They both made a fortune in the stock market. Yet what did they do with the money they had earned in stocks? Both of them invested this money in bonds. Wyckoff was once quoted as saying, "I trade in stocks so I can invest in bonds." Both knew the safety and the investment power that only bonds can provide.

Now that we have seen the power and importance of corporate bond issues, we can now turn our attention to the government bond market. Most investors are familiar with these instruments ("Treasuries," as they are called) through the famous 30-year Treasury bond, or "long bond." The yield on this bond is most frequently viewed as the proxy for long-term interest rates. The Federal Reserve Board uses the long bond as a proxy in setting its own Fed Funds interest rate (the rate charged on overnight loans between banks). What most do not realize, however, is how critical the 30-year T-bond is critical to the availability of credit and the money supply in our economy. To understand how the Fed "sets" interest rates and controls the flow of credit and the size of the money supply, consider the following operation:

When the Fed wants to control the money supply, it does so through a process known as "open market operations." It involves the purchasing or selling of government securities (often on a temporary basis) to inject or remove reserves (money) from the banking system. When the Fed wishes to slow down the economy, it sells Treasury securities from its portfolio of U.S. government securities. In doing so, it receives a check from a Treasury dealer drawn on a commercial bank, which reduces the amount of reserves in the banking system. This, in turn, reduces the money supply, which exerts an upward pressure on the Fed Funds rate, which produces a slowdown in economic activity as consumers and businesses adjust spending to reflect higher borrowing costs.

When the Fed wishes to stimulate the economy, its purchases U.S. government securities from Treasury dealers by sending a check to the dealer firm in payment for the purchased bonds. This action increases the amount of reserves in the banking system, which in turn increases the money supply and lowers the Fed Funds rate. This results in stimulating economic activity as consumers and businesses respond to lower borrowing costs. [Source: Keys to Investing in Municipal Bonds, by Gary M. Strumeyer, M.B.A.]

So we see the market's importance in controlling the availability of credit. The bond market is thus an indispensable tool for controlling the economy; it is the very lifeblood of our financial system.

What are the implications of this in today's investing environment? Quite simply, yields (i.e., interest rates) on the long bond have been climbing since October 1998. They show every intention of climbing further in the near future. Yields on the shorter-term 5-year and 10-year Treasury notes have also been climbing in recent months (both of which serve as proxies to further rate increases on the 30-year bond). This in turn has inspired the Fed to embrace a tight money bias, meaning that it plans on continually hiking its Fed Funds rate until the desired effect if achieved, namely, when the economy "slows down." Rest assured, this will not happen without bringing about powerful monetary adjustments and most likely a stock crash with it. This upward tendency in interest rates cannot be anything but negative to the long-term health of our financial system and economy. The long-term upward trend in interest rates seems to be warning of significant problems that lie ahead.

Even worse, the corporate bond market has been slumping in recent months. As recently as last week, the Dow Jones 20 Bond index broke below a critical support level and appear to have begun a collapse in prices. For reasons we have outlined above, this does not bode well for the corporate outlook and sends a message more powerful than even a stock market collapse could send.

Equally portentous, the Municipal Bond Index—a measure of listed U.S. municipal bond prices—displays a nasty appearance on the chart. Prices on the Muni-bond index broke down producing a huge gap on the chart late last year. After a consolidation through the past several months, the decline has resumed once again. Since many large municipalities have taken on massive amounts of debt for various expansion projects in recent years, this does not bode well for our cities, either.

The message of the bond market, quite simply, is a negative one. We must heed its warning and prepare our portfolios for the coming financial storm, for it promises to be a nasty one.