Options Theory: How Bonds Work
September 29, 2022
Today’s video explains why bonds and interest rates move in opposite directions. Here are two companion pieces that will help.
Notes
Interest Rates lie at the epicenter of all that ails the financial markets.
>> Interest rate = Bond Yield <<
1) Why do bond prices FALL when interest rates RISE?
Buy a $1,000 one-year Treasury bond at par value and it pays $10 per quarter ($40 annually) in interest.
When you purchased that bond, it had a yield of 4%.
Those $40 annual interest payments are FIXED.
If you hold that one-year bond to maturity, then you get your $1,000 back plus $40
If you buy an INDIVIDUAL bond and you hold to maturity, you will get whatever the interest payments were plus your principal back. In that sense, there’s no risk of loss.
2) Why then do we see bond funds go down in value?
Why if I want to sell my bond early would I have to sell at a discount?
1) YOU: Own an old bond that pays $40 each year. At the time you purchased it, that was a 4% yield.
Since then, interest rates have risen. New bonds are yield 6%. They’re paying $60 in interest for every $1,000 purchased
You now want to sell your bond.
A) I can buy new bonds for $1,000 that are paying me $60 of interest over the year. 6% yield.
B) I can buy your old bond for $665 that is only paying $40 of interest over the year. Your bond has to go down in value such that the $40 of interest generates a 6% return. OTHERWISE, everyone would be better off buying NEW bonds.
Because interest rates went from 4% to 6% AFTER you bought your bond. The price of the bond would fall from $1,000 to $665.
TLT – 20-year+ treasury bond ETF. It owns a basket of long-term treasury bonds. Holds them for a few years and then sells them and buys new long-term treasury bonds.
If interest rates rise then by the time I sell the bond, 4 to 8 years after I bought it, I may have to sell it at a loss.
3) Now that interest rates are higher, how do I capitalize?
3-month Treasury Bill as the gold standard for what the “Risk-Free rate” is, then it’s 3.36%.
One: Buy interest-bearing instruments like bonds directly through the U.S. government via treasurydirect.gov
Two: Make sure you’re shopping high-yield savings accounts. (2.2%)
Three: Consider putting cash in your brokerage account in a Treasury Bill or T-bond ETF.
Safe/Low volatility (short-end)———————–More volatility (long-end)
BIL, SHY, IEF, TLT
If Fed is going to raise rates to 4.5%, then what? Presumably the economy is in a recession or sluggish and inflation is killed and they turn their attention back to helping employment and they ease rates. That will cause bond prices to go back up.
Here’s what I find difficult.
Scenario One: Stocks were at an all-time high and I could get 3% to 4% risk-free via Treasuries.
Scenario Two: Stocks are 25% to 35% off the highs and I can get 3% to 4% risk-free via Treasuries.
Money invested in T-bills or bond ETFs have the opportunity cost of NOT being invested in the stock market at a steep discount.
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