Author Topic: Please Decipher this statement about bond rates  (Read 1201 times)

Unionville

  • Pencil Stache
  • ****
  • Posts: 565
Please Decipher this statement about bond rates
« on: March 16, 2023, 08:31:44 PM »
When I read a sentence like this below (in bold quotes) - the terminology makes my eyes glaze over, since it says the opposite of my logic. I always think of a bond as something you buy and hold. My logic says, if the Fed raises interest rates next week, Tbills will be more valuable/attractive to buy because their returns will probably higher than this week. Tell me where I'm wrong.

"How interest rates influence bond prices:
This means that when interest rates go up, bond prices go down and when interest rates go down, bond prices go up. Alternatively, if prevailing interest rates are increasing, older bonds become less valuable because their coupon payments are now lower than those of new bonds being offered in the market."
« Last Edit: March 16, 2023, 08:37:11 PM by TodayOhBoy »

RWD

  • Walrus Stache
  • *******
  • Posts: 6529
  • Location: Arizona
Re: Please Decipher this statement about bond rates
« Reply #1 on: March 16, 2023, 08:48:34 PM »
Your logic is correct. If interest rates go up the current bonds are more attractive to buy. Which means older bonds with lower interest rates will be less attractive and hence will sell at a discount compared to the new bonds to reflect the difference in rates.

If you hold a bond to maturity then the fluctuation in price won't directly affect it. It's just when you try to resell it before maturity that the you have to take into account the current interest rates.

Unionville

  • Pencil Stache
  • ****
  • Posts: 565
Re: Please Decipher this statement about bond rates
« Reply #2 on: March 16, 2023, 09:01:54 PM »
Your logic is correct. If interest rates go up the current bonds are more attractive to buy. Which means older bonds with lower interest rates will be less attractive and hence will sell at a discount compared to the new bonds to reflect the difference in rates.

If you hold a bond to maturity then the fluctuation in price won't directly affect it. It's just when you try to resell it before maturity that the you have to take into account the current interest rates.
  Thank you for being so clear.  So, it seems that whenever I hear things in the news about bond prices going up or down - I can probably ignore it, because from what you said, they are probably referring to buyers and sellers who are not holding those bonds until maturity.  Instead, they are referring to people who are buying and selling bonds from each other and not from the originator of the bond. 
« Last Edit: March 16, 2023, 09:04:09 PM by TodayOhBoy »

MustacheAndaHalf

  • Walrus Stache
  • *******
  • Posts: 6633
Re: Please Decipher this statement about bond rates
« Reply #3 on: March 17, 2023, 06:12:59 AM »
I'd suggest viewing it this way: do I like the old rates better or the new rates?

Say previously bonds paid 3% yield, and now pay 5% yield.  Do you like being paid 3% better or being paid 5%?

You prefer 5%, right?  So you don't like the old bonds.  Neither does the market, so those old bonds (paying 3%) drop in price.

CrankAddict

  • Stubble
  • **
  • Posts: 114
  • Age: 49
Re: Please Decipher this statement about bond rates
« Reply #4 on: March 17, 2023, 07:05:43 AM »


I'd suggest viewing it this way: do I like the old rates better or the new rates?

Say previously bonds paid 3% yield, and now pay 5% yield.  Do you like being paid 3% better or being paid 5%?

You prefer 5%, right?  So you don't like the old bonds.  Neither does the market, so those old bonds (paying 3%) drop in price.

That's a good way to summarize, I would just add one small thing -

"You prefer 5%, right?  So you don't like the old bonds.  Neither does the market, so those old bonds (paying 3%) drop in price if you have to sell them early (but remain unchanged if you hold to maturity.)"

reeshau

  • Magnum Stache
  • ******
  • Posts: 2509
  • Location: Houston, TX
  • Former locations: Detroit, Indianapolis, Dublin
Re: Please Decipher this statement about bond rates
« Reply #5 on: March 17, 2023, 07:14:30 AM »
I'd suggest viewing it this way: do I like the old rates better or the new rates?

Say previously bonds paid 3% yield, and now pay 5% yield.  Do you like being paid 3% better or being paid 5%?

You prefer 5%, right?  So you don't like the old bonds.  Neither does the market, so those old bonds (paying 3%) drop in price.

It's not just that they drop in price.  They drop in price so that they pay 5%, too.  That is, the stated coupon would be 5% of your new purchase price.  Conversely, if an old bond paid 9%, its price would increase until the stated coupon paid 5% of your new, market purchase price.

In reality, there is also some adjustment for the return of principle.  And of course markets aren't perfectly efficient.  But the adjustments aren't random; they are symmetrical until the old bond matches current conditions.

MustacheAndaHalf

  • Walrus Stache
  • *******
  • Posts: 6633
Re: Please Decipher this statement about bond rates
« Reply #6 on: March 17, 2023, 09:01:10 AM »
I'd suggest viewing it this way: do I like the old rates better or the new rates?

Say previously bonds paid 3% yield, and now pay 5% yield.  Do you like being paid 3% better or being paid 5%?

You prefer 5%, right?  So you don't like the old bonds.  Neither does the market, so those old bonds (paying 3%) drop in price.

That's a good way to summarize, I would just add one small thing -

"You prefer 5%, right?  So you don't like the old bonds.  Neither does the market, so those old bonds (paying 3%) drop in price if you have to sell them early (but remain unchanged if you hold to maturity.)"
I view the "drop in price" as contradicting "remain unchanged", but I understand what you're saying.  The original bond's par value will be repaid, and the interest payments will continue.  But the drop in bond price comes from the "opportunity cost" of sticking with your 3% bond instead of buying a 5% bond.  You receive the same payments, but buyers of new bonds are receiving higher payments.

Once someone sees the market value of their bonds drop, I claim they need to know about that opportunity cost, and hopefully understand it.  But if someone is never told, and wishes to ignore changes in market price, that decision also has its own merits.  For this latter group, I'd agree they can ignore market prices entirely.

CrankAddict

  • Stubble
  • **
  • Posts: 114
  • Age: 49
Re: Please Decipher this statement about bond rates
« Reply #7 on: March 17, 2023, 10:00:20 AM »



Once someone sees the market value of their bonds drop, I claim they need to know about that opportunity cost, and hopefully understand it.  But if someone is never told, and wishes to ignore changes in market price, that decision also has its own merits.  For this latter group, I'd agree they can ignore market prices entirely.

For the sake of discussion, what do you feel they should/could do with this knowledge?   Replacing their 3% bonds with 5% won't make them anything additional because they have to take a loss on the 3% ones in order to buy the 5% ones, right?  Isn't the market pricing on the 3% bond set precisely such that this becomes a wash?  Of course they may wish to buy additional bonds if they feel 5% is a good return, but that seems independent of the valuation of their existing bonds.


ChpBstrd

  • Walrus Stache
  • *******
  • Posts: 6660
  • Location: A poor and backward Southern state known as minimum wage country
Re: Please Decipher this statement about bond rates
« Reply #8 on: March 17, 2023, 10:38:00 AM »
These discussions always bring back memories from one of my MBA corporate finance classes. At least half the class could not get over the concept that when rates rise, the bonds they already bought will fall in value on the resale market, but will still yield the same and return their principal if held to maturity. The professor spent a whole day mathematically illustrating the point and fielding arguments.

So @TodayOhBoy the confusion you're feeling is perfectly natural!

I'll tell a story to illustrate the point:

1) Suppose bonds sell for $1,000 each. At the end of the bond's term, bondholders get their $1k back.

2) Suppose the yield being offered changes over time.

3) Suppose you buy a 10-year bond for $1,000 at a time when bonds yield 3%. You'll be paid $30 a year, in 2 installments, for the next ten years. Along with your last interest payment, the issuer gives you back your $1,000.

4) Next year, your 10-year bond is a 9-year bond. It's still paying a "coupon" of 3% per year compared to your original investment.

5) However, by next year rates have changed. Now anyone can buy 9-year bonds on the open market yielding 6%. The new bonds' coupon is $60/year, which is higher than the $30/year you're earning.

6) You'd rather earn 6% than 3% so you put your bond on the market for the original $1,000 you paid. NOBODY will buy your bond. Why would they, when they too would rather earn 6% than 3%?

7) So you start cutting the price. You start with $10 off, move on to $25 off, chop $100 off... and so on. Still nobody will buy your bond. You get desperate and keep cutting, vowing to sell that low-yielding bond at whatever price possible so you can get that 6% yield!!!

8) Eventually somebody buys your 9-year bond with a $30/year coupon for $793.70.

9) You buy a bond yielding 6%.

10) Then you realize what happened. From the perspective of the person who paid $793.70, the bond you sold has a 6% yield to maturity, because at the end of 9 years they'll make a profit from getting back the original $1,000 you invested, plus they'll collect all those smaller coupons in the meantime. They purchased your old low-yielding bond because the price had been cut to the point the yield to maturity equaled the yield they could get from buying any other similar bond from anybody else. You merely sold a 6% yielding bond to buy another 6% yielding bond!
----------------------
In this story, you experienced a capital loss of (1000-793.70=) $206.30, or 20.6%, not counting the $30 in coupons received for holding the bond a year.

However, you didn't really gain or lose compared to your initial position because the $793.70 was put to work in a new 6%-yielding bond. This is less money than you originally had invested, but it's earning a bigger coupon every 6 months. The return in nominal dollar terms will equal the return had you held the original bond with the 3% coupon. That's why the other person was willing to buy your old bond. It was essentially the same deal as they could get anywhere else in the market.

Your bond sold for the price it did because the present value of the future cash flows was the same as it would be if your buyer had chosen instead to get a brand new bond with a 6% coupon. It was merely a tradeoff between getting bigger coupon payments or getting a bigger return of principal in the end.

See this bond calculator: https://www.omnicalculator.com/finance/bond-price

Unionville

  • Pencil Stache
  • ****
  • Posts: 565
Re: Please Decipher this statement about bond rates
« Reply #9 on: March 17, 2023, 11:21:02 AM »
These discussions always bring back memories from one of my MBA corporate finance classes. At least half the class could not get over the concept that when rates rise, the bonds they already bought will fall in value on the resale market, but will still yield the same and return their principal if held to maturity. The professor spent a whole day mathematically illustrating the point and fielding arguments.

So @TodayOhBoy the confusion you're feeling is perfectly natural!

I'll tell a story to illustrate the point:

1) Suppose bonds sell for $1,000 each. At the end of the bond's term, bondholders get their $1k back.

2) Suppose the yield being offered changes over time.

3) Suppose you buy a 10-year bond for $1,000 at a time when bonds yield 3%. You'll be paid $30 a year, in 2 installments, for the next ten years. Along with your last interest payment, the issuer gives you back your $1,000.

4) Next year, your 10-year bond is a 9-year bond. It's still paying a "coupon" of 3% per year compared to your original investment.

5) However, by next year rates have changed. Now anyone can buy 9-year bonds on the open market yielding 6%. The new bonds' coupon is $60/year, which is higher than the $30/year you're earning.

6) You'd rather earn 6% than 3% so you put your bond on the market for the original $1,000 you paid. NOBODY will buy your bond. Why would they, when they too would rather earn 6% than 3%?

7) So you start cutting the price. You start with $10 off, move on to $25 off, chop $100 off... and so on. Still nobody will buy your bond. You get desperate and keep cutting, vowing to sell that low-yielding bond at whatever price possible so you can get that 6% yield!!!

8) Eventually somebody buys your 9-year bond with a $30/year coupon for $793.70.

9) You buy a bond yielding 6%.

10) Then you realize what happened. From the perspective of the person who paid $793.70, the bond you sold has a 6% yield to maturity, because at the end of 9 years they'll make a profit from getting back the original $1,000 you invested, plus they'll collect all those smaller coupons in the meantime. They purchased your old low-yielding bond because the price had been cut to the point the yield to maturity equaled the yield they could get from buying any other similar bond from anybody else. You merely sold a 6% yielding bond to buy another 6% yielding bond!
----------------------
In this story, you experienced a capital loss of (1000-793.70=) $206.30, or 20.6%, not counting the $30 in coupons received for holding the bond a year.

However, you didn't really gain or lose compared to your initial position because the $793.70 was put to work in a new 6%-yielding bond. This is less money than you originally had invested, but it's earning a bigger coupon every 6 months. The return in nominal dollar terms will equal the return had you held the original bond with the 3% coupon. That's why the other person was willing to buy your old bond. It was essentially the same deal as they could get anywhere else in the market.

Your bond sold for the price it did because the present value of the future cash flows was the same as it would be if your buyer had chosen instead to get a brand new bond with a 6% coupon. It was merely a tradeoff between getting bigger coupon payments or getting a bigger return of principal in the end.

See this bond calculator: https://www.omnicalculator.com/finance/bond-price

Thanks for your explanation with examples!  It confirms I'm not a slow learner - but that this can indeed be confusing (if your MBA class couldn't grasp it).  The word bond means so much more than what one would think!  In a way - it sounds like bonds are almost traded like stocks, whereas I was living with the viewpoint that people actually intend to keep bonds, or they shouldn't have bought it in the first place. But perhaps only 1% of the population actually keep the bonds they bought.  And all along I thought bonds were the sleepy, like having a savings account.

RWD

  • Walrus Stache
  • *******
  • Posts: 6529
  • Location: Arizona
Re: Please Decipher this statement about bond rates
« Reply #10 on: March 17, 2023, 11:38:42 AM »
You should also keep in mind there are bond index funds which many people hold as a natural part of their asset allocation instead of buying individual bonds. These will also be affected by interest rate changes. People do buy/hold these but there's no clear start/end date so the price will continuously fluctuate. Even if you aren't liquidating part of your portfolio the act of rebalancing can lock in the bond price changes.

Boll weevil

  • Stubble
  • **
  • Posts: 203
Re: Please Decipher this statement about bond rates
« Reply #11 on: March 17, 2023, 02:44:33 PM »
Your logic is correct. If interest rates go up the current bonds are more attractive to buy. Which means older bonds with lower interest rates will be less attractive and hence will sell at a discount compared to the new bonds to reflect the difference in rates.

If you hold a bond to maturity then the fluctuation in price won't directly affect it. It's just when you try to resell it before maturity that the you have to take into account the current interest rates.
  Thank you for being so clear.  So, it seems that whenever I hear things in the news about bond prices going up or down - I can probably ignore it, because from what you said, they are probably referring to buyers and sellers who are not holding those bonds until maturity.  Instead, they are referring to people who are buying and selling bonds from each other and not from the originator of the bond.

Whether or not you can ignore it depends on what financial rules you are subject to or you are holding yourself to.

Silicon Valley Bank had a combination of assets that had to be and did not have to be “marked to market” (updated to closing price at the end of the day). In their non-mark to market ledger were a bunch of bonds that they intended to keep to maturity. Unfortunately for them, a run on the bank occurred, and they had to start selling those bonds at a loss.

Zamboni

  • Magnum Stache
  • ******
  • Posts: 3882
Re: Please Decipher this statement about bond rates
« Reply #12 on: March 17, 2023, 03:06:09 PM »
ptf thanks

Michael in ABQ

  • Magnum Stache
  • ******
  • Posts: 2626
Re: Please Decipher this statement about bond rates
« Reply #13 on: March 17, 2023, 03:14:42 PM »
Thanks for your explanation with examples!  It confirms I'm not a slow learner - but that this can indeed be confusing (if your MBA class couldn't grasp it).  The word bond means so much more than what one would think!  In a way - it sounds like bonds are almost traded like stocks, whereas I was living with the viewpoint that people actually intend to keep bonds, or they shouldn't have bought it in the first place. But perhaps only 1% of the population actually keep the bonds they bought.  And all along I thought bonds were the sleepy, like having a savings account.

Bonds are where the real money is made on Wall Street. Partially because the market is less efficient (larger spreads = larger profits for intermediaries) and partially because it's just a larger market. The US bond market is roughly $40 trillion in market capitalization compared to roughly $20 trillion for equities.

blue_green_sparks

  • Bristles
  • ***
  • Posts: 479
  • FIRE'd 2018
Re: Please Decipher this statement about bond rates
« Reply #14 on: March 17, 2023, 03:25:21 PM »
When calculating the instantaneous net worth of my portfolio and if I know for sure I will hold a bond to maturity I will "correct" the current value assigned by my brokerage because in the case of rising rates, the drop from par value is only a temporary paper loss.

Unionville

  • Pencil Stache
  • ****
  • Posts: 565
Re: Please Decipher this statement about bond rates
« Reply #15 on: March 17, 2023, 04:21:16 PM »
Quote from: Boll weevil link=topic=130272.msg3126273#msg3126273
Silicon Valley Bank had a combination of assets that had to be and did not have to be “marked to market” (updated to closing price at the end of the day). In their non-mark to market ledger were a bunch of bonds that they intended to keep to maturity. Unfortunately for them, a run on the bank occurred, and they had to start selling those bonds at a loss.

I'm no investing analyst , but even I was scratching my head wondering why they would have bought long term bonds.  All the rates I've been seeing, even with CDs - is that the best deals are shorter term. 
« Last Edit: March 17, 2023, 04:55:38 PM by TodayOhBoy »

Unionville

  • Pencil Stache
  • ****
  • Posts: 565
Re: Please Decipher this statement about bond rates
« Reply #16 on: March 17, 2023, 04:29:42 PM »
Bonds are where the real money is made on Wall Street. Partially because the market is less efficient (larger spreads = larger profits for intermediaries) and partially because it's just a larger market. The US bond market is roughly $40 trillion in market capitalization compared to roughly $20 trillion for equities.

For real?  Never would have guessed that.  I wonder why they have a reputation as being boring.  Most of the financial news seems to be 95% stock news.  But maybe when toto pulls the curtain there's a big party going on.

Michael in ABQ

  • Magnum Stache
  • ******
  • Posts: 2626
Re: Please Decipher this statement about bond rates
« Reply #17 on: March 17, 2023, 04:46:57 PM »
Bonds are where the real money is made on Wall Street. Partially because the market is less efficient (larger spreads = larger profits for intermediaries) and partially because it's just a larger market. The US bond market is roughly $40 trillion in market capitalization compared to roughly $20 trillion for equities.

For real?  Never would have guessed that.  I wonder why they have a reputation as being boring.  Most of the financial news seems to be 95% stock news.  But maybe when toto pulls the curtain there's a big party going on.

Watch "The Big Short" all the investments they're talking about are bonds. It wasn't housing stocks or bank stocks they were shorting; it was mortgage-backed securities (aka bonds).

You can't just go online and buy a lot of these bonds as an individual investor. There is usually a broker and they can price them however they want since they're relatively illiquid and usually purchased only by institutional investors spending hundreds of thousands or millions of dollars.

Boll weevil

  • Stubble
  • **
  • Posts: 203
Re: Please Decipher this statement about bond rates
« Reply #18 on: March 17, 2023, 04:55:38 PM »
[quote author=Boll weevil link=topic=130272.msg3126273#msg3126273
Silicon Valley Bank had a combination of assets that had to be and did not have to be “marked to market” (updated to closing price at the end of the day). In their non-mark to market ledger were a bunch of bonds that they intended to keep to maturity. Unfortunately for them, a run on the bank occurred, and they had to start selling those bonds at a loss.

I'm no investing analyst , but even I was scratching my head wondering why they would have bought long term bonds.  All the rates I've been seeing, even with CDs - is that the best deals are shorter term.
[/quote]

I had to look this up, but the answer seems to be at the time the bonds were purchased, the long term rates were higher. Long term bonds typically have higher interest rates, but they fell below the short term rates in December.

Heliios

  • 5 O'Clock Shadow
  • *
  • Posts: 21
Re: Please Decipher this statement about bond rates
« Reply #19 on: March 17, 2023, 06:07:49 PM »
If interest rates fall, selling your bonds early can be quite profitable--one point in favor of not just thinking about face value at maturity. That said, I prefer equities to bonds any day.

MustacheAndaHalf

  • Walrus Stache
  • *******
  • Posts: 6633
Re: Please Decipher this statement about bond rates
« Reply #20 on: March 17, 2023, 08:40:01 PM »
Once someone sees the market value of their bonds drop, I claim they need to know about that opportunity cost, and hopefully understand it.  But if someone is never told, and wishes to ignore changes in market price, that decision also has its own merits.  For this latter group, I'd agree they can ignore market prices entirely.
For the sake of discussion, what do you feel they should/could do with this knowledge?   Replacing their 3% bonds with 5% won't make them anything additional because they have to take a loss on the 3% ones in order to buy the 5% ones, right?  Isn't the market pricing on the 3% bond set precisely such that this becomes a wash?  Of course they may wish to buy additional bonds if they feel 5% is a good return, but that seems independent of the valuation of their existing bonds.
My comment was aimed primarily at forum users here.  Some people view bonds as not losing money, as separate from the bond market prices.  That's fine, but once a thread talks of market prices and bond funds, I claim market prices are the focus.

You brought up all bonds get repriced and have the same return, which is accurate - but the bonds aren't identical.  The 3% bond was bought at a discount, and at maturity that discount returns as a taxable gain (at orindary income tax rates).  Over the life of a true 5% bond, the interest payments are higher.

I haven't done it myself, but I think you can tax loss harvest a 3% bond that fell in value.  You could sell it, buy something not "substantially identical" (avoid IRS wash sale) and have a taxable loss.  You could invest the money you save on taxes.

vand

  • Handlebar Stache
  • *****
  • Posts: 2304
  • Location: UK
Re: Please Decipher this statement about bond rates
« Reply #21 on: March 18, 2023, 04:31:55 AM »
There's not much to decipher - interest rates are the inverse of the bond's mark-to-market value.  Same as a dividend yield is the function of its current shareprice.

New bonds are continually being issued with new coupon rates, which sets the price of existing bonds in the secondary markets. If the Fed decides it wants to issue bonds paying 5% tomorrow then those 2% bonds it issued last year are worth a lot less as the mark-to-market capital value falls to bring its coupon payments into line with new bonds for the same amount of capital.

 

Wow, a phone plan for fifteen bucks!