How the Market Works
How the Market Works and Why You Care: Bonds 101
Posted by kdadmin on September 21st, 2015.
Now that the Fed has made its (wimpy) policy decision, and before the first quarter earnings numbers come out (in ten days), it’s time for a bit of education. No, not the “boring, face down on your desk because you ran out of caffeine”kind. But the “choose a topic you’re interested in and go research it until you pass out at your desk,” AMI Montessori kind.
I’m not kidding. Bonds are actually pretty cool when it comes to making money in a crummy market. Although, I guess you have to be interested in making money …
So, here’s the situation, my parents went away for a week’s vacation … (Sorry, I couldn’t resist. I miss the Fresh Prince and DJ Jazzy Jeff.)
Anyway, bonds. Since the Fed’s didn’t raise interest rates, and the market remembered that not everything was rosy in global economics, AND we now have a large portion of our investment portfolio in bonds, I thought a brief primer was in order. If you’ve ever had debt, you have experience with the basics of bonds. A bond is a debt. Someone borrowed some money from someone else and promised to pay them back over a certain period of time at a certain interest rate. The risk to the lender is that the borrower will not pay them (default). The risk to the borrower is that the lender is charging them too much interest. That’s it. No mystery.
Let’s try an example.
- Lenny borrowed $1,000 fromCarl and promised to pay him back in 10 years.
- Lenny will pay Carl 15% interest at the end of each year.
- At the end of 10 years, Lenny will pay Carl his $1,000 + the 15% due for that year.
- Carl will earn $150 per year (15% of $1,000) for taking the risk that Lenny will pay him back all of his principal plus interest.
From the specifics of this example, we can surmise a few things about this “bond.”
- This bond is an intermediate term. Historically, 1-3 years is short term. 5-10 years is intermediate term, and 10-30 years is long term. Now, depending upon where interest rates are at the moment, this time range could be adjusted up or down. But, to keep things simple, we’ll use traditional periods.
- By charging Lenny 15% interest, it’s clear that Carl thinks that Lenny might not pay him back. A 15% interest rate is a “high yield” rate. People (and companies) that pay high yield rates usually have some financial difficulties / credit rating issues, and have to compensate their lenders for the additional risk of default by paying a higher rate. In this case, Lenny will pay Carl $150 per year for 10 years. That’s $1500 in interest on a $1,000 loan. Using a high interest rate helps Carl get more of his money back if Lenny defaults on the final repayment.
- If Carl holds Lenny’s debtfor the full 10 year term, his yield to maturity (amount he earns over the remaining lifetime of the debt)will be the same as his interest rate.
Now, let’s say that Mister Burns wants to buy Lenny’s debt (Carl’s bond) from Carl after five years. Carl has a choice. He can wait for Lenny to pay him his principal back in five years + interest in the meantime, or he can sell that privilege to Mister Burns. Let’s say that interest rates have changed in the five years since Lenny borrowed the money from Carl.
- If interest rates for debts like Lenny’s have gone up, then Carl will have to sell his bond at a discount to Mister Burns. Here’s why: If Mister Burns can get 20% interest from other borrowers in the high yield market, why would he pay the full $1,000 for Carl’s bond when it only pays 15%?
- If interest rates for debts like Lenny’s have gone down, then Carl will get to sell his bond at a premium to Mister Burns. Here’s why: If Mister Burns can only get 11% interest from other borrowers in the high yield market, he would gladly pay more than $1,000 for Carl’s bond, since it pays 15%.
Without scrambling your brain too much more, what can we take away from all this?
- If interest rates go up, bond prices go down. (Because new bonds pay higher rates than old bonds.)
- If interest rates go down, bond prices go up. (Because new bonds pay lower rates than old bonds.)
- We are soon going to be in a RISING interest rate market. Bond prices will likely go down.
Now, the $64,000 question is: WHY WOULD I BUY BONDS FOR MY CLIENTS IF INTEREST RATES ARE SET TO RISE IN THE VERY NEAR FUTURE?!
The answer, of course, is more complicated than this basic intro with Lenny and Carl. We’ll cover it in our next segment. In the meantime, I’ll give you a hint, actually two:
- If I own the bond (I’m Carl), what am I getting while I wait for interest rates to rise?
- Technically speaking, click back in time to my January, 2013 post about the bond market.
Last, but not least, bonus points for you if you can figure out why I risked life and limb to hike near a scraggly waterfall on the shores of Lake Thirlmere, in The Lake District of England, to teach you about bond theory.