Author Topic: Bonds explained?  (Read 3704 times)

tannybrown

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Bonds explained?
« on: August 03, 2012, 11:13:42 AM »
I've had bonds explained to me as debt I issue to someone (a govt, a company, etc.) and they agree to pay me back a certain amount of interest.

But I keep hearing that when interest rates rise, bonds values may go down...and this continues to confuse me.  Can someone give me a layman's explanation of what's at play here?  My novice brain thinks, hey, the US Government agreed to pay me back 2% so who cares if interest rates go up...what effect does that have on my loan to the govt?


velocistar237

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Re: Bonds explained?
« Reply #1 on: August 03, 2012, 11:40:42 AM »
Bonds can be sold at auction, and then after that re-sold in a secondary market. This doesn't apply to things like the direct purchase of savings bonds, which are sold at a set price.

tooqk4u22

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Re: Bonds explained?
« Reply #2 on: August 03, 2012, 11:58:00 AM »
I've had bonds explained to me as debt I issue to someone (a govt, a company, etc.) and they agree to pay me back a certain amount of interest.

But I keep hearing that when interest rates rise, bonds values may go down...and this continues to confuse me.  Can someone give me a layman's explanation of what's at play here?  My novice brain thinks, hey, the US Government agreed to pay me back 2% so who cares if interest rates go up...what effect does that have on my loan to the govt?

That is correct.  If you hold an individual bond through it maturity the value can go up and down over that timeframe with movement in interest rates, but as long as you hold it you will get your expected return of 2%.  However, if you sell prior to that point you will either lose or gain based on where rates are at that time. 

Example -  You buy $10,000 of 10year US Treasury paying 2%.

If you hold you will get your money back in 10 years plus the 2% per year that you earned while holding.

Lets say you sell in six months but rates for the 10 year notes that are being issued are now 3% (lets ignore there are different rates for remaining time frame i.e. the 5year is lower than the 10yr and there really is no difference between 10 years and 9.5years). 

Today you have have a bond that pays $200/year.  So to get the 3% return you would divide the $200 by 3% giving you a value of $6,667 or a whopping loss of $3,333 (33%).   This is the inherent, and significant, risk in bonds right now.  Some will say this can't or won't happen for a long time but I will point out that 10YR UST was not far from 4% as little as 1.5 years ago and back in December when Europe was on hold and economic date looked more promising 10Y UST went from 1.8% to about 2.4%, which when you are paying it isn't a lot but the impact on the value is big.  Look at a chart of the 10Y UST - there is far more downside than upside.

It is tougher to figure out with bond funds because of mixed durations/risk buckets/trading. 


grantmeaname

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Re: Bonds explained?
« Reply #3 on: August 03, 2012, 12:00:44 PM »
Because they can be sold at auction, bonds appreciate or discount until they are mathematically identical to bonds being sold at other rates.

Let's say you have a $1000 bond with a 4% rate, which you bought last year. This year, due to economic changes, the equivalent bond sells with a 5% rate. At auction, last year's bonds (those with a 5% rate) only have to match a 4% return on capital, because an investor knows that they could also just as easily buy a new $1000 bond that would return 4%. A 5% bond would sell for $800 now, because that's all it's worth--otherwise, why wouldn't you just buy one of those new 4% bonds? Here, the increase in interest rates has caused bonds to appreciate.

On the other hand, if this year's bonds are at 3% and last year's bonds were at 4%, the old 4% $1000 bonds will sell for $1333 because the going rate is $30 per $1000 of capital, so you're willing to pay $1333 to get a $40 return. Thus, when interest decreases, bonds appreciate.

Mr Mark

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Re: Bonds explained?
« Reply #4 on: August 04, 2012, 10:50:17 AM »
Does that help?

So a bond pays a stream of cash, 'interest' on the loan. If interest rates go down, the price of a bond goes up because I'm willing to pay more for that future cash.

And the reverse is true - as rates go up, bonds are worth less. So their price drops for the same future cashflow. So the price of a  (say) $1k bond at a coupon of 4% -  ie it pays out $40 per year - is worth:

At 8%, $500
6%, $750
4% $1000
2% $2000
1% $4000
0.5%  $8000
0.1% $40,000


Note how very nonlinear the price goes as rates tend to zero. (Note - these are nominal rates, usually, and so inflation is an extra problem. The US gov can borrow at less than 2% for 10 years, which is less than expected inflation! These rates are very very low unless you expect deflation, and why rates generally are well above zero.)

This why as rates for US Treasury debt have fallen over the past 40 years, bond returns have been good. Especially over the past 10 years.

So the risk is if rates rise, and they are near historic lows, bond prices will fall. But if rates stay low or go just a bit lower over the next few years or decades bonds could do very well indeed....

Which is why even now I hold 15 - 20% intermediate term bonds.
« Last Edit: August 04, 2012, 10:56:15 AM by Mr Mark »

tooqk4u22

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Re: Bonds explained?
« Reply #5 on: August 05, 2012, 10:21:07 AM »
I don't disagree with you Mr Mark but you need to factor in that a portion of the rate right now is fear based on flooded with global demand, otherwise they wouldn't be priced below inflation.  Once (if) Europe settles down, and it doesn't have to be fixed, we will see treasuries go up 50-100 bps assuming no other changes (+/-) in economic climate.