Monday, April 11, 2016

Bonds Are Bad Investments .... They Aren't 'Safe' Either

By One Measure, U.S. Rates Are Already Negative is subtitled 'Yield on 10-year Treasuries, adjusted for inflation, falls below zero . . . .' Since a picture is said to worth a thousand words, consider the following graph:

For illustrative purposes, if the stated interest rate on a $100 bond (coupon rate or stated yield) is 2% when issued and the market interest rate immediately increases to 4%, that 2% bond is immediately worth 50% of what it sold for initially.

That's due to the simple math calculation of the $100 face or par value of the bond being 'marked to market' as the market interest rates have changed after the initial issuance of the bond.

If the market adjustment weren't made to the already issued and outstanding bond, nobody would be willing to buy it from the owner. They would simply wait and buy a newly issued bond with a coupon rate of 4% since new bonds would yield 4% in the new 4% interest rate environment.

Thus, all other things being equal, the 2% yielding bond is now worth $50, or half as much, in a 4% interest rate environment. By marking it to market, it becomes easily tradable in the bond market as interest rates fluctuate after the bond's issuance. {NOTE: We'll set aside a discussion of credit risk, sovereign risk, currency risk and the maturity risk (how long the bond will be outstanding) for now. That can all be explained later.}

In any event, bonds have been good investments for the past 35 years as interest rates have declined from double digits to less than 2% nominally and less than zero in inflation adjusted terms.

As interest rates climb over the next several years, bond prices will fall in value. And the more rates rise, the more bond prices will fall.

It's that simple.

Thanks. Bob.

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