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Wall Street Steward Blog

Principal and Interest: How the Bond Market Works

TRANSCRIPT AVAILABLE

Hi folks. My name is Matt Griffin. Thank you for visiting wallstreetsteward.com.

We’ve been getting comments and feedbacks recently about improve the lighting in the film room, or maybe do more videos standing or sitting or wearing different things, that sort of thing. I will tell you thank you very much for your feedback. We will implement some of these things. However, as I’ve shared with you before, I’m not a big believer in scripts. So, if I write something wrong or do the math wrong or drop my pen or have to run to the restroom or anything like that, it’s going to be on the video because that’s the only way it’s real to me.

That being said, I recently had a conversation with a potential investor. He asked me about this “bond bubble” talk that he keeps hearing about. You know, aren’t bonds safe? I can’t lose money in bonds, can I? How can that be? How could I lose money in something that’s as safe as bonds?

Bonds can be safe. They also can be volatile. Let me explain. I have three small children. I have a five year old, a three year old and a one year old. So, if there’s one thing I understand, its seesaws, ok? When one goes up, the other one goes down and vice versa. And if anyone of you out there knows my son, you know he will act like a chimpanzee if he does not get his way. He turns into a chimp snap at record speed. Like I said, I understand seesaws.

The bond market, in general, works like a seesaw. For example, on this side we have principal. Let’s say, for arguments sake, we invest $10,000 into a bond and the interest rate, the seesaw is level when we first purchase the bond, so the interest rate let’s say is 3%. So, interest rates in the economy are at 3%. That’s why the seesaw is level. That means, simply, that that institution, if it’s a government bond, it’s the government paying the interest, if it’s a corporate bond, it’s the company paying the interest. But whoever the issuer is agrees to pay you $300 per year for however long you own that bond.

Now, one of the other advantages of a bond is it has a stated maturity date. For arguments sake, let’s say it’s a ten year bond, ok. What that means is if you hold that bond for ten years, on that date in ten years, assuming your issuer is still around, you’re going to get your $10,000 back. And they’re going to pay you $300 a year while you wait. That’s owning a bond. You’re actually a creditor of the corporation. You’re lending money to them by buying a bond and they’re going to pay your money back in ten years. And you’re going to earn interest rates.

Now, how does it act like a seesaw? Very simple. When you first buy it, the seesaw is level. Market rate is 3%. Rates in the economy are 3%. So, the seesaw is level. Now, we invested $10,000. If interest rates go down in the economy, so let’s say they go down to 2%. Well, we’ve locked in at 3%, so we’ve locked in a superior rate of return. Now, it’s a ten year bond. So, we probably wouldn’t sell that bond, because we’ve locked in a better rate than most people can get today at the current environment. However, if we were to sell that bond early, would we sell it for $10,000? Of course not! We bought it for $10,000, but we locked in a better rate. We can’t replace that rate anymore. So, if we had to sell this, we would ask for a premium. So, in other words, somebody’s going to probably have to pay us, I don’t know, $10,300 and again, the pricing will be done by the brokerage firm and people that are smarter than me. So, it may not be $10,300, maybe its $10,100. That being said, you’ll get more money for your bond than you put into it, if you sell it early.

Conversely, we put $10,000 into this bond; interest rates were at 3% when we bought it. What if rates go up? Let’s say they go to 5%. And we’ve now locked in an inferior rate of return. We bought a bond and locked n 3% for ten years and then the current rate went to 5%. This is sort of like showing up at your local retailer and buying a big screen TV and you’re all excited and you get it home and you take it out of the wrapper and you set up and you and your family are all excited and then a week later they drop the price 30% at the retail store. And you just want to go in there and let them hear about it. Not that that’s ever happened to me, but so I’ve heard, that can be a little frustrating folks. I digress. You buy the bond at 3%. Interest rates in the economy go up 5%. Now, if I’m another potential buyer and I can put $10,000 in a bond at the current market rate, which is 5% or I can buy your bond from you at 3%. Which one am I going to buy? Clearly, I’m going to try and earn a higher interest rate so I can go make up for that television purchase.

Now, unless you’re willing to take less for your bond. In other words, you put $10,000 in it, but you locked in a bad interest rate. So, maybe now it’s worth $9,500. Well, if you sell me that bond at $9,500 I might be willing to buy yours, because it’s going to mature in ten years at $10,000 on that date in ten years. So, I’m collecting interest and I’m going to get a little bit of appreciation when that bond matures.

Now, think about the current interest rate environment we’re in right now. Rates are not at an all time low, but they’re still very low. I don’t know that we can get a whole lot lower. I mean the ten year treasury as of this filming is paying right around 3%. So, if you locked the bond in for ten years, you’re going to earn 3% a year. Now, do we think over the next five, ten, twenty, thirty years rates are going to go substantially higher or substantially lower? Folks, they can only go down to zero, and I don’t think the federal government is ever going to be paying zero on their treasury bonds. That being said, can it go higher? Yes, it can go higher and it can go higher for a long period of time. Now, I don’t think we’re going to sky rocket any time soon. However, don’t have this sense that if you put in $100,000 into a portfolio of bonds and you lock in at today’s prices and interest rates, let’s say the ten year treasury goes back to 5-5 ½%. Is it possible that this is going to be $90,000? Absolutely! Ok? If interest rates go up, bond prices go down, you will lose money on an unrealized basis.

Now, there are some other factors that go into this. The higher the credit quality, typically, the less sensitive they are to interest rates. Say you have a safe kid who wants to sit right here on the seesaw and not way out here on the end. Alright? So, then as interest rates go up, your bond only goes up or down a little bit. Ok? So, less sensitive to interest rates. However, if you own some below investment grade bonds, bonds issued by companies that are in trouble, then you’re way out here on the scale. A small move in interest rates can throw you off of the seesaw or you could lose a lot of money.

Now, the other thing that comes into play here is maturity. In other words, if you buy a one year bond and you lock it in and interest rates go up, it’s only going to down a little bit because it matures in a year at your par value. So, if you’re locked in at very short term maturity, one year, three years, five years, something like that, you’re probably not as interest rate sensitive as someone who locks it in phone rings and there’s the phone ringing. Again we don’t script this stuff folks. We just take it as it comes. So, hopefully voicemail will pick that up. And it did, thank goodness. So where was I? Again, if we lock in short term bonds, we’re not as interest rate sensitive. However, if you lock in bonds at a twenty and thirty and forty years from maturity, you are very interest rate sensitive. Ok?

That being said, some of these products like preferreds and things like that. They have perpetual maturities. Look closely. Perpetual is code word for it never matures. Or, it matures in about forty, fifty, sixty years. Alright? Now, those investments might be suitable for you. I’m not saying they’re not. However, just understand what a move in interest rates could do to that portfolio if you own them. That being said, when you hear this talk about a “bond bubble” or the “bond bubble will burst” or “bonds will underperform.” What they’re saying is, they believe, long term, interest rate have no way to go but up. So, your principal is going to drop if you lock in today at today’s current rates.

Now, there’s a lot of factors that go into this discussion as far as risk tolerance, suitability, time frame, reduction of volatility, and things like that. I’ll try not to put you to sleep by getting into a lot of that right now. Contact your financial advisor. Have this conversation if this makes you nervous.

Thank you very much for listening. Keep sending your feedback and we’ll talk to you soon.