This essay is an attempt to explain the mechanisms behind the valuation of bonds.
Bonds are contracts
A bond is a contract. It is essentially a post-dated "check" for a given amount that is auctioned of at some point in time. All examples in this essay will be for a check with an "amount payable" of $1000.
Suppose the prevailing interest rates are 5% and you wanted to "buy" a check that is post-dated for next year and you went to an auction to make that buy. You would expect to pay $950 because that is 95% of $1000.
Further suppose that the interest rates went up to 10% over night and that you needed to sell that bond the next day. "Checks" written for $1000 post-dated for one year are now selling for $900 (90% of $1000). The best price you can get for your "check" is $900. That is, you lost money when the interest rates went up.
Effect of duration
Compound interest is a miracle. It multiplies an investment over time. It also multiplies losses.
|This table shows the Net Present Value (the price you could expect to pay) for a "check" post-dated with various durations. Arbitrary interest rates were chosen to span possible futures.|
In general, interest rates go up when risk goes up.
Economic downturns often see bond yields drop at the start of the downturn. That is because investors are selling stocks (equities) because they are perceived as being riskier than bonds. The investors move the money to bonds. More investors drives the price of the bonds up....which is the same as driving the interest rates down.
Later in the downturn, there will be a flight to quality bonds and shorter duration bonds as companies go bankrupt and unsecured creditors are hosed. "Junk" bonds, i.e. high return bonds are sold into a market with few buyers. Bond prices drop on that class of bond and the quoted interest rate skyrockets.
One way that little investors, like me, can avoid being trampled by the stampede is to be two seismic shifts ahead of the herd. That is why I abandoned the Efficient Frontier and moved a portion of my money into short duration, government securities. I believe that the rest of the herd is strung out behind me and I like having a good seat at the watering hole.
Benjamin Graham, the father of modern securities analysis (1934) is generally thought of as a "stock" picker. But word is that he made most of his money buying "secured" bonds at a huge discount. The fact that they were "secured" meant that he recouped the entire face value of those bonds when the properties that were collateral were sold.
---Kubota just walked in the door. He is loopy and I need to sign off.---