Shaken, Not Stirred.
A number of guest writers have thankfully provided their take on topics covering sports journalism, the economics of college athletics, the serious crisis in Lebanon, the meetings and events industry, and various other takes. Today’s guest writer provides insight into the world of bonds, a financial product that has always been a bit of a mystery. As a baseline:
- The bond market broadly describes a marketplace where investors buy debt securities that are brought to the market by either governmental entities or publicly-traded corporations.
- National governments generally use the proceeds from bonds to finance infrastructural improvements and pay down debts.
- Companies issue bonds to raise the capital needed to maintain operations, grow their product lines, or open new locations.
Thanks to JP for his info and take:
Why should you own bonds? What are bonds? I have worked in the bond market for the past 35 years and I always get asked by friends “what are bonds?” are so I figured I may as well share some knowledge here. Thank you, Gary, for the opportunity.
Bonds Defined: As a simple definition, a bond is an IOU issued by a corporation, government, or government- sponsored entity, or municipality. It has a defined maturity and pays an annual rate of interest, typically on a semiannual basis.
What don’t I know about bonds? One clear benefit. Because bonds are IOU’s, they are from a capital perspective above equity (stockholders) in case of a bankruptcy. Huh? Well, if you own Apple stock and Apple bonds….and Apple were to go into bankruptcy and then into a company liquidation…. the first to get paid are the bond holders! That is right! All bank loans and bond holders get paid before the stockholders. So, in a worst-case scenario (bankruptcies/liquidations) …. the stockholders can get wiped out completely, while the bond owners would still get some of or possibly all of the principal they paid returned to them. Do you remember the financial collapse of 2008? If you owned Lehman Brothers stock, it went to zero. If you owned Lehman Brothers bonds, during liquidation they would have still paid out 40 to 50 cents on the dollar…. better than losing it all in the stock!
What is the size of the bond market versus the stock market? Thru 2019, the size of the U.S. stock market was $37.5 trillion, and the bond market $41.2 trillion. Globally, all of the stock markets combined total $95 trillion, and the bond markets $128 trillion.
How do bond prices and yields work? Yields and prices work in opposite directions on bonds. So, when interest rates increase…. bond prices decrease…. but if you hold a bond to maturity…..no matter what interest rates do…..you will be paid back at par (100) absent a default or bankruptcy. This is different than owning a bond fund. In a bond fund, interest rates and what other investors in the fund do can affect a gain or loss for you. Bond funds do not have a final maturity but rather a targeted duration.
Where are current US Treasury Bond Yields?
Why do yields go up? Yields on bonds are the market’s perception of inflation going forward. Rates will rise when the economy strengthens, signaling the federal reserve to begin raising short term rates to curb the unwanted additional inflation.
How do you measure your risk in bonds…? What is my downside? Let us say you bought a 5-year bond…. a AAA rated U.S. Treasury. You buy $10,000 of the U.S. Treasury 0.75% coupon maturing 3/31/26 at par. So, your yield is 0.75%. These will pay you that interest rate semiannually. So, each year that is $75, paid semiannually so $37.50 every 6 months.
Now let us say that interest rates on these bonds go from 0.75% to 1.50%. The market price of the bond goes from par ($100) to $96.40 or a paper loss of 3.6 points. That would be if you wanted to sell the bonds. If rates stay at 1.50% …. you still get paid $100 at maturity or $10,000….so only a loss if you sell them prior to the maturity date.
The longer the maturity (or duration) of a bond, the more the price changes for the same change in rates. So, on a 10-year U.S. Treasury at par ($100) with a 1.625% coupon with the same rate move of .75% to 2.375% in interest rates, the price moves to approximately $94.40 or a paper loss of approximately 5.60 points. Again, you still get paid your $10,000 at maturity if you do not sell them prior to maturity.
What if I want more yield? You can increase the yield you get by either lengthening the maturity of the bond you purchase or go down in credit quality. Since U.S. Treasury bonds are rated AAA, other bonds such as corporate bonds trade at a “spread” or yield on top of what U.S. Treasury’s yield. For example, in the above where 5-year Treasury’s yield 0.75%, a 5-year corporate bond such as Apple which are AA rated trade at a +.35 spread to the 5-year or 1.25% yield 1.10% (U.S. Treasury 0.75% +.35 spread = 1.10%). Or an Apple 10-year bond which trades at a +.40% spread to the 10-year treasury would yield 2.025% (U.S. Treasury 1.625% +.40 spread = 2.025%)
The lower the credit rating, the higher the spread and the higher the yield. The more risk you take, the bigger the reward.
What is duration? Duration is the weighted average maturity of the bond’s cash flows. This takes into consideration the interest rate the bond pays you as well as the final maturity. So, a five-year bond with a 3% coupon has a shorter duration than a five-year bond with a 2% coupon.
Why are interest rates and bond yields so low? The short answer is “QE” Quantitative Easing. QE is a form of unconventional monetary policy in which a central bank (like the Federal Reserve) purchases securities (bonds or some countries’ stocks) in the open market in order to increase money supply and encourage lending. This policy expands the central bank’s balance sheet and lowers interest rates. QE is typically used when a central bank has already lowered short rates as far as they can but still wants to drive down interest rates for longer maturities. Currently the Fed’s balance sheet is at $7.7 trillion and is growing at the pace of $120 Billion every month.
How do I invest in bonds? Most online brokerage firms have inventories of bonds to review. These can be U.S. Treasury bonds, Corporate bonds, Government Agency Bonds, or Municipal bonds. You can also purchase U.S. Treasury Bonds directly from the U.S. Government at this website:
https://www.treasurydirect.gov/indiv/research/indepth/tbonds/res_tbond_buy.htm
SpaceX’s Used Vehicle Does It Again.
I have enough issues navigating Orlando’s Colonial Drive when heading to my local Publix Supermarket. Then, for the second time, I try to understand how SpaceX’s reused Crew Dragon links up with the International Space Station (ISS) 264 miles above the Indian Ocean. Let’s be very clear, I don’t understand how the Crew-2 and the ISS even come close to each other twenty-three hours after liftoff, nonetheless dock while on the same orbital path. Based on JP’s analysis of the bond market, I would expect he could tell us how this is possible? 🙂
No Winner Here.
- Guilty on all three counts. The reading of the verdict by the judge was even-keeled and decisive. There really is no winner in the George Floyd/Derek Chauvin case – other than the process of a jury trial. What actually came out of this trial was a 12-person jury, whittled down from a pool of more than 300 potential candidates, made up of one Black woman, two multiracial women, two White men, three Black men, and four White women. Most under 40. This mix of people were charged with deciding one of the highest profile cases in recent memory, and without editorializing, provided the Court with a verdict that reverberated across the country.
As I posted two weeks ago, Derek Chauvin did not have the intention of ending George Floyd’s life. As the unfortunate circumstances unfolded, including Floyd resisting the police officers’ effort to place him in their car, Chauvin’s emotion and machismo led to a terrible act of judgment, one that will put him in prison for many years. The justice system was the only ‘winner’ here – a jury trial that provided the proper due diligence with a very difficult case. Difficult in many ways, including the Judge’s decision not to sequester the jury and two alternates.
Caitlyn On The Run.
California – one of my favorite states to visit, from Carlsbad to the Central Coast, and of course the Pacific Coast Highway leading you through the twists and turns leading up to the amazing town of Carmel. I had to yield way to my visits to the west coast due to the pandemic, but it is now probably time to visit California, that if a sovereign nation, would rank as the world’s fifth largest economy. It is also a state whose front-runner for governor is Caitlyn Jenner. The last time I saw Jenner as a front-runner was when he was in the throws of winning the 1976 Olympic decathlon gold medal. California: an amazing state to say the least. Run Caitlyn, Run!
Paying It Forward.
- Now for some news that makes you smile. Speaking of paying it forward, an LSU fraternity did a great thing for their former fraternity house cook. A kind gesture to say the least that sheds a bit of light on a week of news to forget.
Great lesson on Bonds. Thanks JP… is Caitlyn (Bruce) really the front runner? I wonder what would happen to California “keeping up with Caitlyn”. Indeed run Caitlyn, run…