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How the Market Works

How the Market Works and Why You Care: Bonds 102

Posted by kdadmin on September 25th, 2015.

How the Market Works and Why You Care: Bonds 102

As the market tries to figure out what it’s going to be when it grows up, let’s try to make money in the meantime by continuing with our bond primer. If you haven’t read How the Market Works and Why You Care: Bonds 101, start there. You’ll need to understand the basic reason that bond prices operating inversely with interest rates. It may even shed some light on Lenny and Carl’s relationship.

Today, we’ll address the $64,000 question from Bonds 101. Namely, “Why would I buy bonds for my clients if interest rates are set to rise in the very near future?!”

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Before I do that, however, let’s cover the reason that I traveled to Lake Thirlmere to teach you about bond theory. When I saw that craggy river ripping randomly down that narrow crevice, I thought, “Hey, this would be a great analogy for bond cash flows!” And then I managed to nearly fall into that very crevice more than once. Luckily, I didn’t get that foolishness on film, so my Right Said Fred reputation is still intact.

Anyway, a quick definition of bond cash flow is “the income (distributions, interest or dividends) paid to the owner of a bond (the one who lent the money) while they wait to receive the return of their principal at the end of the bond’s term.” This is what I was getting at in hint number one from Bonds 101. Carl is enjoying cash flow from his bonds while he waits for interest rates to rise. The picture above is Lake Thirlmere, the benefactor of that craggy river’s flow. Just like this river does with mountain water; bond cash flows, over time, can create a remarkable reserve of wealth.

Let’s try an example:

  1. IF Carl thinks that bond interest rates might go up.
  2. AND IF that means that Mister Burns will only buy Carl’s bond at a discount (because future bonds will pay higher rates).
  3. BUT Lenny is paying 2.85% per year to Carl in the meantime.
  4. AND nobody really knows when rates will go up.
  5. THEN Carl will enjoy the 2.85% income from his bond in the meantime.

The Rub. (And not the good kind.)

  1. IF interest rates go up much more quickly than the market expects,
  2. THEN the amount that Carl will have to discount his bond to sell it could now be much more than 2.85%

In other words, the amount of interest rate change has a huge, Huge, HUGE impact on the price change of bonds. Hence the media’s obsession with what happens to the Federal Funds Rate. Well, ONE part of the their obsession, anyway.

What can you take away from this?

  1. Holding a bond in a volatile interest rate market has its perks (income from bond cash flows).
  2. Carl had better be darn sure he knows what’s happening with interest rates.
  3. By holding his bond in a rising interest rate market, Carl is essentially playing chicken with the bond market.
  4. There’s nothing wrong with playing chicken, but Carlhasto know when to get out.
  5. Carl had better know how to do the math to figure out how a change in interest rates would likely affect his portfolio. Or, he had better hire someone who does.

The Answer to the $64,000 Question. As you can imagine, I have great research sources to validate what I think is happening with interest rates. I know how to do the math to figure out how much risk my clients are facing in their bond portfolios. More importantly, I know how to tilt the risk/reward balance in my favor. As such, I would rather see them enjoy income (bond cash flows) while they wait for the Federal Funds Rate to change; than languish in cash much longer.

Next time, we’ll cover the basics of how to tilt the risk/reward balance in YOUR favor.

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