THIS IS MY 104TH BLOG ON UNDERSTANDING MONEY
TOOLS
In this blog we are going to revisit bonds. I discussed stocks and bonds quite
thoroughly in previous blogs written perhaps 2 years ago.
The reason for the recap of what bonds are is that most
experts believe the bond market is at it’s high, most likely not trend higher
but decline before the end of the year.
What is a bond?
It is a position of debt, not equity; an IOU at some point in the
future. Bonds can come from
various entities, public and private. Some public forms being city, county,
state (municipal) and Federal (US bonds). Most private bonds being corporate
including publicly traded companies.
Why the feeling that the market value for bonds will come
down? Bonds are interest rate
sensitive. Many people think that if they invest in bonds they are safe and
can’t lose money, wrong. You can lose just like in equities (stocks) in the
stock market, but for different reasons.
How is this possible? One
is that bonds are rated, and all-important is the quality of the bond and the
company that rated the bonds (reflect on 2008!). Another variable is your ability to hold the bond to
maturity, did you buy a 10 year bond or the very popular US, 30 year bond that
mortgage rates are so related to?
Billions of bonds are traded in the after market each day.
Why might the market for bonds take a big hit? The Federal Reserve has kept interest
rates artificially low since the recession of 2008. They are eager to extricate themselves from these Keynesian
policies, but have been reluctant to raise rates which should lower stock
market values as well as the bond market. As a person noticed, the Feds left
the interest rates remain low at their meeting August 26th in
Wyoming. They certainly weren’t going to raise rates just prior to a
presidential election, however the next logical move upward will be in
December. The bond market and
interest rates are always opposed to one another; if interest rates go up, the
market value for your bond will go down, adjusting for expected returns. Logical, yes?
The next question is historically what sort of adjustment in
bond price can I expect? The past
formula has been that the drop in value will be the duration to maturity of
your bond for every 1% the rates go up. Example: if I have a 30 year US bond with 21 years remaining and the
Federal Reserve raises the interest rate 1%, I can assume the market value of
my bond to drop 21%. If the Feds
raise interest rates 1/2%, the drop would be 1/2 of 21% or 10.5%.
Let me place a “caveat emptor” into this piece. We could be “whipsawed” by the
Feds. Let’s assume Janet Yellen
and the Feds raise rates in the near future. What that naturally does is strengthen the dollar (more
foreign money will seek strength), it will diminish our current exports because
the dollar is stronger against other currencies and our already weak economy
will get weaker (current GDP at 1.1%).
As I have been writing for quite some time on the topic it is only a
matter of time before we join the rest of the world in recession. Almost all major countries are in very
poor shape, including all the more powerful oil producers like Russia, Brazil,
Venezuela, Saudi Arabia, Iran, etc.
If GDP drops and we have no growth for two or more quarters that is a
defined recession. Janet Yellen
will then most likely drop interest rates again, perhaps going negative like
Japan, Switzerland and other countries have done. What would this do to the market value of bonds? Well, the bonds that hold any interest
to speak of would increase in value.
That’s about all for a quick update on bonds. We will see what the Feds do with
rates.
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