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Investments for the Rest of Us: Keep Your Eye on the Bond Market
Published Date
The United States 10-year Treasury bond increased in price, pushing the yield to the lowest in history — 1.68 percent — as investors looked for safety in our benchmark bond. Bonds can be confusing to many until you understand how they work.A bond is really just an IOU. When you buy a bond from the government or a corporation, the bond (IOU) comes with a fixed rate of interest (that's why you'll hear bonds referred to as fixed income). That fixed interest rate is sometimes called the coupon, because bonds actually used to come with coupons you cut off and took to the bank for payment.
Interest is calculated against the bond's "par" value, think "normal" value, usually $1,000 or $10,000 in the case of some government debt. A bond paying 3 percent against a par value of $1,000 will always pay $30 a year. This is what it might look like:
Bank of America 10-year 3 percent bond par value $1,000 maturity 05/31/2022
If you buy this bond, you are lending $1,000 to Bank of America for 10 years, for which they will pay you a coupon (interest payment) of 3 percent. Payment will be made every six months in May and November in the amount of $15.
That's the easy part.
Every day, your Bank of America bond will have a new price. In fact, it will have a new price just about every second twenty-four hours a day. It's the movement of the price that changes the yield. Remember that the "coupon" or interest payment doesn't change. The bond pays 3 percent of par value ($1,000), or $30 a year, regardless of the bond's price. What happens if new bonds being issued by Bank of America or some other corporation have a 4 percent coupon at par? The new bond pays $40 a year instead of $30. All things being equal, your 3 percent bond is not as valuable.
What if you want to sell your bond at 3 percent when new ones are available at 4 percent? This is where the price movement comes in. The only way you can sell your bond is to lower the price from $1,000 to $750 to allow $30 to equal the 4 percent yield ($30/$750 = 4 percent).
It works in reverse as well. If new bonds are being issued with a 2 percent coupon, $20 a year at par, the price of your bond is increased to equalize the "yield" to the investor with prevailing rates. In this case, your Bank of America bond could be sold for $2,000 ($40/$2000 = 2 percent). The math isn't actually quite this neat and the movements are seldom this large, but you get the idea.
What makes a yield on the 10-year Treasury below 1.7 percent such a big deal is that it has never been this low before. In other words, investors are flocking to the perceived safety of our government's bond and are willing to accept a negative real return.
In the investment business, we refer to real and nominal returns. The nominal return is simply the stated rate of return. The real return is the investment return less inflation. Inflation erodes the value of your money. As an investor, you have to equal inflation just to break even. If your nominal return is below the inflation rate, you are quite simply losing money.
Currently, inflation is about 2 percent a year. At 1.68 percent, investors buying the 10-year U.S. government debt are willing to accept a negative real return. Certainly some of these investors are counting on the price to go up even higher, lowering the yield even further (see above) and allowing them to sell the bonds at a profit.
Regardless of an investor's motive, a yield this low is communicating to us that professional investors are very worried about the future. I say professional investors because bond market participants tend to be pros; very few individuals buy bonds directly. This fact, combined with the size of the bond market (seven times as large as the stock market), means this is the market you want to pay attention to.
If we pay attention, the bond markets can tell us a great deal about the future. Right now, bond traders globally are communicating their belief in a messy default in Greece and, possibly, the imminent breakup of the Euro. Additionally, bond investors are factoring in a recession in Europe and a continued slowing of both the Chinese and American economies.
In the very near future, we will begin to see investors price-in the expiration of the Bush tax cuts, as well as, a fight over the debt ceiling increase at the end of the year. These worries will drive prices higher and yield even lower, freeing the Federal Reserve to engage in another round of Quantitative Easing (money printing). Until QE is on everyone's lips again, bonds will, as crazy as it seems, most likely outperform stocks. QE will undoubtedly provide another lift to stocks, until we start this all over again.
Until then, forget the stock market. If you want to know the future, keep an eye on the tea leaves of the bond market.
David F. Brochu, CFP, is president and CEO of KLEOSSUM advisers, an independent investment advisory firm for individuals and group retirement plans, residing in Tech Village in Conway. For more information e-mail This email address is being protected from spambots. You need JavaScript enabled to view it. , call (603) 733-4290, or visit online at www.KLEOSSUM.com.
Do you have an investment or economic question that might be of interest to you? Please feel free to e-mail us for a future column of INVESTMENTS FOR THE REST OF US, published every other Wednesday in The Conway Daily Sun.
