Our bond market could offer some investment opportunities in the coming year if the Tea Party has its way. So here is a little insight in understanding the mechanics of bonds (as usual, I might get shot for over simplification).
If we were to buy a 30 year $10,000 bond at issue, at par, at an interest rate of 4.50% it would pay $450 each and every year for 30 years. Next year, suppose that interest rates jumped to 9%. Now if you were to buy a 10k bond at issue, it would pay $900 per year. That is double the interest rate of the bond bought the year before.
So if you are fleet of foot, you think, let’s sell the bond only paying 4.50%. Well guess what, the only bid you will get, will be for $5,000. It takes two old bonds to pay the same interest as one new bond. If you hold the lower paying bond to maturity, you will get your full 10k, but in the meantime, the newer bond by comparison paid twice the interest.
Several things affect the interest rate on a bond, the risk, and the length of the contract and market news. Another thing to consider is how low are interest rates? And will they go any lower Once you get to a yield of 3%, you can’t go much lower, but from there your risk of the rate going higher are almost a sure bet. Buying a 20 year Greek bond paying 33% interest means you get your investment back in 3 years (I'm lying, you're being robbed). The issuers of the bond are not paying that interest rate; it is the bond holders discounting the price, trying to unload a hot potato.
If we were to have a liquidity crisis, bonds offered for sale,would have few buyers, especially if they were small company bonds. As bonds prices drop, the interest rate paid, goes up.
Here is where the money is to be made. For example, a person purchases a 30 year 10K bond at issue with a 3% coupon, purchase price $10,000. Let’s figure that interest rates jump to 12% and that person needs to raise cash fast and decides to sell that 10K bond. The market would discount the bond to $2,500. That's the bond to buy. The new buyer gets 12% interest ($300) on his $2,500 investment. At maturity in 30 years, the bond pays $10,000, a capital gain of $7,500 on a $2,500 investment. The potential exists for higher rates; 12% though could be on the high side.
So as a rule of thumb with long term bonds, if interest rates double, the current value of the bond drops 50 percent. That could be the opportunity to take dollars out of the bank and buy bonds. Presently, interest rates are too low; risk and inflation have not been properly priced into rates. With the current budget crisis, the bond market is like a sleeping dragon---a loud Tea Party could wake it up.
As a side note of Interest
I have a sitemeter at the bottom of my blog and it gives me info on my viewers. I clicked on this one viewer in Washington DC and got a bit of a surprise, I just had to take a picture. Welcome to my blog whoever you are. Very few people use Apple computers.