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I feel as though I have a fairly good handle on financial matters. I know what an ETF is, how to calculate net present value, how to compare publicly traded stocks based on price:earnings, take advantage of tax shelters, etc, etc. However, this thing called the "bond market" is utterly opaque to me. People speak of it in reverent tones, and it's often described as being far larger than the stock market. How does it work? Who's borrowing and lending? I know that percentage yields and bond prices move oppositely, but I don't particularly understand why this the case, and whether there's a time lag involved or whatever. I often see comments on financial blogs to the effect of "The US -year bond closed at X percent today" written in a knowing tone, and have no idea how to process such a statement. The whole thing is just a big mysterious black box to me, and presumably I'm not alone in this. Please help, bond experts of BFC.
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| # ? Jan 26, 2013 16:03 |
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| # ? May 20, 2013 08:14 |
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I'm no expert, but my brother makes lots of money as a bond trader, so I'll try to help. With a stock, you've purchased a share in that company. A bond is essentially a note saying the company (or government/institution) will pay you back, plus with some extra dividends over time. Many bonds are ten year bonds, so you get the initial investment back at the end of 10 years (plus the extra dividends/interest payments over that 10 year period). The question becomes, how reliable is is this institution? When you buy a US treasury bond (also called a t-bill), it's virtually guaranteed to be paid back unless the US government collapses. Low risk, so you get a low reward in the form of very small dividends over the course of the loan. The higher risk, let's say buying bonds from the Greek government, the more you should expect in monthly dividends. It's like banks charging a higher rate of interest when loaning to people with bad credit, as they are seen as less likely to pay the money back. I can park my money in t-bills briefly as a safe (but low yielding) investment. If I want my money 2 years into a 10 year bond, I just sell the bond on the market. Now somebody else has the t-bill, which has only 8 years left. Maybe in the short time I've had the t-bill, the US government has become less stable. The terms of the bond stay the same, meaning whoever holds it at the end gets the initial bond price/investment back, and the same monthly dividends. If it's now riskier though, I can't sell it to somebody for what I bought it for, because the reward part of the equation has stayed the same, but the risk is now higher. So that's why bonds change prices.
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| # ? Jan 26, 2013 18:32 |
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Particle409 pretty much nailed it - I would just add that bonds are how the federal reserve controls interest rates buying government bonds when they want rates to go down (and money supply to increase) and selling them when they want rates to go up.
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| # ? Jan 27, 2013 02:07 |
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particle409 posted:I can park my money in t-bills briefly as a safe (but low yielding) investment. If I want my money 2 years into a 10 year bond, I just sell the bond on the market. Now somebody else has the t-bill, which has only 8 years left. Maybe in the short time I've had the t-bill, the US government has become less stable. The terms of the bond stay the same, meaning whoever holds it at the end gets the initial bond price/investment back, and the same monthly dividends. If it's now riskier though, I can't sell it to somebody for what I bought it for, because the reward part of the equation has stayed the same, but the risk is now higher. So that's why bonds change prices. Ok, but suppose the credit worthiness of the US government remains constant; i.e. essentially infinite. Say you bought it yielding 2%, then 4 years in you want to sell, but the federal reserve's inflation targeting policies by that point are such that 10-year bonds are now available at a 3% rate. That makes your 2% bond (with 6 years left) less valuable -> discount, but also, does the shorter time horizon factor in at all? Thanks to you both for the answers!
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| # ? Jan 27, 2013 03:19 |
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Lexicon posted:Ok, but suppose the credit worthiness of the US government remains constant; i.e. essentially infinite. Say you bought it yielding 2%, then 4 years in you want to sell, but the federal reserve's inflation targeting policies by that point are such that 10-year bonds are now available at a 3% rate. That makes your 2% bond (with 6 years left) less valuable -> discount, but also, does the shorter time horizon factor in at all? Yeah, your bond is now less valuable. Think about it, you can sell your 2% bond and purchase a 3% one. Nobody will want to buy your 2% bond though, if they can buy a 3% one at the same price, so you need to offer a discount. The time horizon doesn't really matter too much, as it's assumed you can always sell your bond at any time on the bond market. Companies quite often park their money in t-bills for a few days. If they end up with a bunch of liquid capital coming in, but can't utilize it immediately, they buy some t-bills and then sell them a few days later. edit: I think I'm wrong on the time horizon. particle409 fucked around with this message at Jan 27, 2013 around 05:34 |
| # ? Jan 27, 2013 03:56 |
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particle409 posted:Yeah, your bond is now less valuable. Think about it, you can sell your 2% bond and purchase a 3% one. Nobody will want to buy your 2% bond though, if they can buy a 3% one at the same price, so you need to offer a discount. Makes sense. And presumably the "natural" market price difference between the 2% and the 3% will make them equal in NPV terms? Assuming sufficient liquidity etc?
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| # ? Jan 27, 2013 04:08 |
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Lexicon posted:Makes sense. And presumably the "natural" market price difference between the 2% and the 3% will make them equal in NPV terms? Assuming sufficient liquidity etc? Actually, let me think about that. I may have to revise my comments on the bond's maturity date being a factor. In calculating the NPV of a bond, you do have to input the number of compounding periods. Think about it: A bond with a great rate is valuable, but if it matures in a couple months, it's not as valuable as a bond with a great rate that matures in a couple years. You have a longer time period of that great rate throwing off money.
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| # ? Jan 27, 2013 05:33 |
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Isn't the PV of a bond just the value of its future cash flows discounted to present value? That would include interest payments as well as the repayment of the principal. If I'm thinking about this correctly, this method would accurately value the bond on, say, a balance sheet. On the market, the price should be inflated or discounted to reflect the yield delta of the same bond (or a bond with the same risk profile). In other words, and as particle409 already mentioned, nobody would want to buy your 2% bond when they could get the same bond with a 3% yield, unless your price was reduced to make up the difference.
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| # ? Jan 27, 2013 10:50 |
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Are bond rates and interests rates inversely related? So with interest rates so low, would now be a good time to invest in bonds?
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| # ? Jan 27, 2013 20:44 |
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dogpower posted:Are bond rates and interests rates inversely related? Someone who knows what they are talking about should correct me if necessary, but I'm pretty sure now bond prices are pretty high precisely because interest rates are so low. Since interest rates have no where to go but up, it should therefore follow that bond prices have nowhere to go but down.
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| # ? Jan 27, 2013 21:35 |
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Lexicon had it correct. Bond coupon rates (the actual money you get from the person who issued the bond) is inversely related to the price. If you think about it intuitively, it makes sense. The yield on the bond should always (assuming rational investor/perfect information, etc) equal the market rate for similar instruments. If the coupon rate on the bond is 5% and the market is yielding 7%, the price must go down to give investors a 7% yield on their money. The yield would come from the discount on the bond (you buy a $1,000 face value bond for, say, $900) plus the payments the bond issues (5% on a $1,000 face paid semi-annually would be $25 every 6 months).
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| # ? Jan 27, 2013 21:40 |
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jaymm posted:Lexicon had it correct. Bond coupon rates (the actual money you get from the person who issued the bond) is inversely related to the price. If you think about it intuitively, it makes sense. The yield on the bond should always (assuming rational investor/perfect information, etc) equal the market rate for similar instruments. If the coupon rate on the bond is 5% and the market is yielding 7%, the price must go down to give investors a 7% yield on their money. The yield would come from the discount on the bond (you buy a $1,000 face value bond for, say, $900) plus the payments the bond issues (5% on a $1,000 face paid semi-annually would be $25 every 6 months). So what's a risk-averse entity to do when it's pretty well assured that bond prices are at a local maxima for the time being? Just keep money as cash? Is it possible that a portfolio with X% bonds and (100-X)% equities could actually be made safer decreasing X? Or am I over thinking this?
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| # ? Jan 27, 2013 22:18 |
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Lexicon posted:So what's a risk-averse entity to do when it's pretty well assured that bond prices are at a local maxima for the time being? Just keep money as cash? I would say most companies are doing this. See companies like Apple with $40 billion+ cash.
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| # ? Jan 27, 2013 22:40 |
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Lexicon posted:So what's a risk-averse entity to do when it's pretty well assured that bond prices are at a local maxima for the time being? Just keep money as cash? What do you mean by "cash"? If I buy a 1-year bond with 100$ face value for 99$, I'll make a dollar by next year. It doesn't matter if equivalent 1-year bonds sell for 97$ then. If I kept those 99$ as "cash" I wouldn't earn any interest.
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| # ? Jan 28, 2013 01:01 |
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dogpower posted:Are bond rates and interests rates inversely related? Bond rates and interest rates are directly related, so no.
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| # ? Jan 28, 2013 01:41 |
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ShimaTetsuo posted:What do you mean by "cash"? So you're saying the capital "stored" in an existing bond cannot ever drop, assuming the solvency of the issuing party? That makes a certain amount of sense, but would seem to be in contradiction to the point made by jaymm - this being a 'bad' time to invest in bonds. This whole question is basically a great illustration of my issue in fully understanding bonds - snippets of information make total sense in isolation, but I can't easily reason through things like this.
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| # ? Jan 28, 2013 02:35 |
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Lexicon posted:So you're saying the capital "stored" in an existing bond cannot ever drop, assuming the solvency of the issuing party? That makes a certain amount of sense, but would seem to be in contradiction to the point made by jaymm - this being a 'bad' time to invest in bonds. Let's put some numbers in it then. Let's suppose we have a 2% 2-year bond selling at 100. This bond allows us to receive $10 in 6 months, $10 in a year, $10 in 18 months, and $1010 in 2 years (interest plus principal). Discounted to present value at a 2% rate that is worth $1000. But if interest rates jumped instantly to 3%, the present value of those cash flows are $9.85, $9.71, $9.57, and $952.02, total $982.25. So the $1000 principal of the bond is still there, but if interest rates have increased $1000 in two years is worth less than it was before. However, if it was my plan to hold the bond to maturity, I will still have $1040 in two years, which is exactly what I wanted at the time.
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| # ? Jan 28, 2013 03:00 |
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Hobologist posted:Let's put some numbers in it then. Let's suppose we have a 2% 2-year bond selling at 100. This bond allows us to receive $10 in 6 months, $10 in a year, $10 in 18 months, and $1010 in 2 years (interest plus principal). Discounted to present value at a 2% rate that is worth $1000. But if interest rates jumped instantly to 3%, the present value of those cash flows are $9.85, $9.71, $9.57, and $952.02, total $982.25. So the $1000 principal of the bond is still there, but if interest rates have increased $1000 in two years is worth less than it was before. I see, thanks. So really the bond-price/interest-rate relationship should be more appropriately stated as as "present value of bonds as a marketable instrument varies inversely with interest rates". And that would seem to hold whether you're talking about existing bonds or new issues. I think this is the root of the confusion that I've had - present value versus nominal value.
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| # ? Jan 28, 2013 03:18 |
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Lexicon posted:I see, thanks. So really the bond-price/interest-rate relationship should be more appropriately stated as as "present value of bonds as a marketable instrument varies inversely with interest rates". And that would seem to hold whether you're talking about existing bonds or new issues. I think this is the root of the confusion that I've had - present value versus nominal value. What exactly do you mean by "interest rates"? The rate of return on the bond? Or the prevailing risk-free rate?
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| # ? Jan 28, 2013 20:30 |
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Sits on Pilster posted:What exactly do you mean by "interest rates"? The rate of return on the bond? Or the prevailing risk-free rate? The latter, or to be more specific, the general trend of all "interest rates" ultimately set by changes in the prevailing risk-free rate. So basically: Interest rates in general trend upwards due to an increase in risk-free rate set by central bank => rate of return on new bond issues increases => present value of existing bonds drops (with no nominal change to either coupon distributions or the final redemption principal at the end of the term). Does that sound reasonable? If that's correct, I think I'm finally on board with this stuff, and if not, I remain as lost as ever.
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| # ? Jan 28, 2013 20:54 |
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Lexicon posted:The latter, or to be more specific, the general trend of all "interest rates" ultimately set by changes in the prevailing risk-free rate. Not quite. Bond prices change as a result of plain old market supply and demand all the time, not just when the central banks meet (and buy/sell a whole bunch of bonds). The coupon structure and the principal are fixed for the lifetime of the bond: these are CONTRACT terms that you agree to when you purchase the bond. The VALUE of that contract (the price of the bond) changes through time due to supply and demand, and this IMPLIES changes in "interest rates" (which are measured/estimated from bond data). edit: It's a "bad time to invest in bonds" because you probably won't win outside of collecting the principal (i.e. an entirely risk-free profit of precisely the absolute minimum amount you will accept to tie up your funds for a period of time). You can (probably) do better by accepting "some" risk. Many market participants also do not purchase bonds with the intention of keeping them to maturity (like most people don't buy pork belly futures because they want to own a whole bunch of dead pigs). ShimaTetsuo fucked around with this message at Jan 28, 2013 around 23:31 |
| # ? Jan 28, 2013 23:22 |
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Bonds have a lot of pros and cons. Pros: They are a fixed-income asset and are generally safer/less volatile than stocks for a couple reasons, the main one being is that if a company files for bankruptcy, bondholders are listed as creditors above equity holders. Cons: Extremely subject to erosion of purchasing power (inflation). For example, if you buy a ten year treasury bill at 2 percent and the inflation rate is 3 percent over the aggregate period, you have "lost" money. This isn't much of a risk in the short term but in the long term if, for example, the United States or whatever country you are in experiences hyper-inflation, your investment is subject to lose significant value because there is no way altering the interest rate. Contrast this to other assets such as real estate (you can charge tenants more rent), stocks (companies can pass off higher costs) or gold/silver (function as a hedge against inflation because of their scarcity, history as money, fungibility, etc).
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| # ? Jan 29, 2013 05:50 |
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Lexicon posted:So you're saying the capital "stored" in an existing bond cannot ever drop, assuming the solvency of the issuing party? That makes a certain amount of sense, but would seem to be in contradiction to the point made by jaymm - this being a 'bad' time to invest in bonds. As others are pointing out (but not using this exact language), it's all about opportunity cost. If you have a bond with a 2% rate you got last week, but now there are bonds available with 3% rates, you're losing 1% in opportunity cost. That's how the whole loan business works. You borrow money at one rate, and hope to use that money to get back a higher rate than what you've borrowed it at. That's what the government plans to do with the money from the bonds. Sort of.
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| # ? Jan 29, 2013 08:41 |
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| # ? May 20, 2013 08:14 |
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Inflation increases kill bonds. That said who knew my 1.5% treasuries would shoot up like a rocket because rates went lower. I sold them recently. I think if you buy and rates decrease you make a killing. If rates go up you get boned.
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| # ? Jan 29, 2013 21:23 |
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