Marc Cuniberti: The ins and outs of bond investing
One the most difficult concepts for investors to understand is the relationship between bonds and interest rates. Know first that bonds are just “I owe yous,” and although many investors can’t describe exactly what a bond is, it is as easy as rereading the last sentence over again.
A bond is an “I owe you” and being such means when you buy a bond, you are loaning money to someone. For the loan, you’ll hopefully get your money back (in lieu of a default where you lose some or all of your money) and get paid a “gratuity” of sorts for loaning out your cash. That gratuity is really just the annual interest rate you’ll be paid, either periodically (installment payments paid usually quarterly, semi- annually or annually) or at the end of the loan, where you’ll get your money back and your interest for the entire loan.
When interest rates move in the general economy, it can affect the price of certain bonds more than others because of a mechanism called opportunity cost.
To illustrate, assume an investor agrees to lend out his money for a day and buys an “I owe you” called a day bond. The issuer of the bond (the borrower, also known as the issuer of the bond) agrees to pay back the bond tomorrow. In exchange for this one day bond, the borrower agrees to pay five percent interest on top of the money he borrowed. Assuming he borrowed $100, he will pay back $105, the extra five dollars being the interest.
Now assume interest rates increase for whatever reason (of which there are many) and causes interest rates to rise everywhere (usually the case). One day bonds now pay six percent.
The effect on the buyer who bought yesterday’s one day bond at five percent?
Probably nothing as the loan is only for a day and tomorrow the buyer can buy a new bond at the new rate of six percent. No harm, no foul.
Assume now the buyer decides the next day to buy an “I owe you” with a ten year payback. The term of the bond (maturity date) is now not one day but ten years. Assuming the interest rate is 10 percent because the lender (bond buyer) has to go without his money for ten long years instead of a day (hence the higher interest rate).
Once again let’s assume for whatever reason the interest rises in the general economy (causing rates to rise on everything), and now ten year bonds, whose interest rates rose as rates rose around them, now pay 15 percent.
Here is where the pain part in bond investing comes in. Since new ten year bonds now pay 15 percent, and the original buyer is only getting 10 percent, this buyer is now locked in for ten years at an interest rate that is lower then everything offered now that rates have risen.
In essence the income of the bond to the buyer is 10 percent, but had he not bought the bond, he could now get 15 percent. His opportunity cost is therefore 15 percent while he is only getting 10.
He is now losing five percent every year. If he needed to get his money out for some unforeseen reason, and had to sell his bond, no one would buy it as it only pays ten percent while current bonds pay 15.
The fact is he could sell his ten year bond, but since it pays less than current bonds, he has to sell his bond at a discount to entice a buyer.
Since the new buyer will lose five percent in opportunity cost because he is buying a bond paying 10 percent when he could buy a bond paying 15, he demands the bond be sold under its face value. If it was a $10,000 bond, he might only pay $5,000 for it.
He will get paid the full value of the bond of $10,000 which sounds great (paying $5,000 and getting back $10,000) but in reality, over the ten years he lost that much in opportunity cost. In other words, got five percent less interest than he could have by buying a current bond paying 15.
In a nutshell, because new bonds are issued all the time, anytime there an interest rate move in the general economy, the price of bonds can rise or fall. The longer the maturity (time to payback) the more the move in the bond when interest rates move (remember our “one day” bond example).
Although the math to calculate how much of a loss or gain will be if interest rates move is complicated, the understanding how and which way a bond moves is easily condensed.
The longer the bond (longer time to payback also known as the term or maturity), the more the price of the bond will move in response to interest rates. If rates rise, longer term bonds will fall more than short term bonds, and if rates fall, the opposite will occur.
This article expresses the opinions of Marc Cuniberti and are opinions only and should not be construed or acted upon as individual investment advice. Mr. Cuniberti is an Investment Advisor Representative through Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Marc can be contacted at SMC Wealth Management, 164 Maple St #1, Auburn, CA 95603 (530) 559-1214. SMC and Cambridge are not affiliated. His website is http://www.moneymanagementradio.com. California Insurance License # OL34249. Bonds have risks. You can lose money. Both partial and total loss is possible.
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