As suggested by my title, today’s thoughts turn to the mountain of U.S. debt that will spur hyperinflation, send wheelbarrow sales into orbit, turn ‘Merica into Greece and, in the end, kill us all. Yep. I just went all apocalyptic pundit on you and it felt icky. So now that the requisite hyperbole and buzzwords on debt have been uttered, here’s my actual objective for today: shed light on bonds and interest rates and how to trade them.
The bond market is a wonderful place where borrowers and savers meet to fulfill each other’s needs. Borrowers need money. It’s debt they’re seeking and they want it now. Savers have money but are scared of the insidious little imp called inflation. If the cash hoard ain’t growing over time, then its purchasing power is, sadly, shrinking. That, and savers are greedy buggers who want even more money. So, they’ll naturally help borrowers out, but only for a fee. That fee is interest, a rate of return to compensate lenders for their troubles. They are, after all, tying up their money so it can’t be used elsewhere (what the cool kids call opportunity cost). Plus, there’s a risk the borrower won’t repay.
Countries, corporations, and municipalities all head to the bond market to borrow and savers the world over head there to lend. In contrast to the stock market, where investors become owners, in the bond market investors become loaners.
The price of a bond depends on all sorts of factors like duration, credit risk of the borrower, and interest rates to name a few. Let’s focus on interest rates since the denizens of the Street are so obsessed with their eventual rise.
Bond prices and interest rates are perched on opposing sides of a teeter-totter. Here’s why. Suppose you bought a 10-year Treasury bond with a yield of 3%. Every year the borrower (debt-laden Uncle Sam in this case) pays you 3% interest for your troubles. A year passes and interest rates rise to 4%. That is, new Treasury bonds are being issued which yield 4%. Also, it turns out, you want to buy a Ferrari and need the money you lent out when you bought your bond last year. To get your money, out you’ll need to sell your bond to someone else. You come to me since I’m such a nice guy and, more importantly, am a saver with cash I want to invest in bonds. The conversation goes something like this:
You: “Hello Tyler! You’re looking mighty nice this morning.”
Me: “Why thanks. I got a haircut.”
You: “You want to buy my Treasury Bond from me? It yields 3% and Uncle Sam will totally pay you back.”
Me: “Well, you know old Sammy is issuing new bonds that yield 4% so no way I’m gonna buy your bond unless you sell it at a discount. I mean, I’m sorry, but the price of your bond must fall to be competitive with new bonds being issued with higher yields. Blame it on the rise in interest rates, buddy.
You: “Curse Janet Yellen! She should lower rates again.”
Me: “Write her a letter. I’m sure she reads all her fan mail and will totally heed your advice since she’s obviously a dunderhead. She only has a massive education and enough experience to become the Fed chair.”
You: “Yeah, I’ll do that.”
And that’s basically how it works. Rates rise, bond prices fall. …or rates fall and bond prices rise. In my example, rates could have fallen so that new bonds were yielding 2%. In that environment, you would be able to sell your bond (yielding 3%) at a hefty premium to what you originally bought it for since your bond is more attractive than the ones currently being offered by Uncle Sam.
So how do you trade bonds and track interest rates and all that? That, my friends, is a tale for another time. Next Wednesday to be specific. Pearls of wisdom will fly. Ya don’t wanna miss it!
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