Saturday, July 30, 2011

Bonds, A Future Investment Opportunity

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.


Sackerson said...


- if we have any cash then.

Anonymous said...

Nice visitor.

Anonymous said...

Jim- Your math is correct, but the one "flaw" in your idea is the time frame. Most people will be in their 50's or 60's before they buy bonds. Buying a 30 year bond at age 50 means that you probably will have been dead for 3 years, before you get your principal back.
Unless you know something the rest of us don't, you "can't take it with you." However, if you can buy a Ferrari in heaven, I'm in!

Jim in San Marcos said...

Hi Anon 7:23

When I first wrote this piece, it was twice as long and I deleted a part that I should have left in.

As we approach retirement we tent to look for investments that are very liquid. Cash in the bank is paying 1% interest. If you use the rule of 72, it takes 72 years to double your investment, so at retirement you are living pretty much on principle.

Now if we were lucky enough to have rates jump to 12% and using the rule of 72 you would have your investment back in 6 years. In that time frame, interest rates could return to a more normal rate and you could sell the bonds and also realize a capital gain.

The irritating thing is that your 401K is doing just the opposite. They buy the long term 3% bonds to lock in a guaranteed yield and eliminate risk for their older investors.

If you were to think like a fund manager, you might just take the 3% bond money and "invest" it in hedge funds. After all, the 30 year 3% bonds will always be there. This wouldn't be illegal, but it exposes your clients to more risk.

When you say you can't take it with you, a lot of seniors are doing just that with credit cards. Debts are not inheritable. If your 70, buy the Ferrari now, the cemetery can't forward your credit card bills.

raptor said...

How do invest for this scenario...
Excluding Treasury Direct (??).
ETF's like TBT also seem like a lousy way of doing it, too..

Tyrone said...


HSBC to lose 30,000 bodies...

Link: HSBC BANK TO CUT 30,000 JOBS 8-1-2011

Jim in San Marcos said...

Hi Raptor

The easiest way will be with corporate bonds. They reflect more of an interest spread than Treasuries.

Anonymous said...

I don't know Jim. Corp bonds are risky, espec in a depression. Govt bonds are risky too. They could be called, maturities extended, coupon rates reduced, etc. Contrary to the standard that the lender makes the rules, the govt is the only borrower that can change or make the rules.

If you're holding cash to buy bonds and inflation comes... you are screwed. If deflation comes you're good. Still a gamble.

Better to buy a small business with your money that has a needed product or service and pay a manager well to run it for you.

frakrak said...

Hi Jim, thanks for the info it sounds like I need to follow in your coat tails for a wealthier lifestyle:) I'll call it the slip-stream effect, the trickle-down effect hasn't helped me all that well:)
And there you go with your "special audience", I can see a consultancy heading your way:)

Jim in San Marcos said...

Hi Anon 12:46

I'm looking for a collapse of the stock market and the bond market. A bond collapse would be nothing more than a high jump in interest rates. I would expect interest rates to calm down within a year or two. If the stock market collapsed, it could be 30 years before it comes back.

Bond holder debt for a corporation is senior to stocks.

I am looking to buy Corp bonds first and then switch into stocks at their lows.

If we were to face hyperinflation, I would expect the bonds to be called or paid off on the spot. A stock certificate would then be a share of ownership if the currency went to hell.

I think what you need to do is value rate your risks. I would consider foreign stock very risky as I would long term low yield bonds. Somebody else might call it different. Here is where you would tinker with your 401k investment strategy. Diversity is the key.

Then the other thing you have to realize, is that people sell their prime assets first, keeping the dogs hoping they will come back. Solid stocks you would never expect to drop, do so for this reason.

There is a lot of risk out there. Very few people can make it themselves starting a business, but if you are successful, that return could be the best of them all.

Anonymous said...

Listened to an interview with a fund manager. His suggestion...
Look at the trend over the last few years of the dividends that the blue chips are paying. They rival that of what you could earn with bonds. Stick with the strong blue chips that people will continue to buy from (goods and services that everyone needs)and you'll be ok in a depressionary climate too.

Anonymous said...

Jim --

How long do you think it will be before the bond market collapses?

Jim in San Marcos said...

Hi Anon 10:56

Dividend yields are a good indicator of value. They support the stock price. That's why everyone use to buy utilities for retirement, they paid decent dividends.

The thing I like about them, is that if the price of the stock drops, the dividend yield goes up. So you can't whine about that unless they cut the dividend.

Jim in San Marcos said...

Hi Anon 3:02

A bond market collapse just means that interest rates spike up. 10% interest rates would trash the existing bonds written with 3% rates; they would face a 66% discount to cash.

Right now, we are seeing very high bond rates in Greece and Ireland. I personally don't think that the interest rates quoted are high enough to cover the default risk the investor assumes.

We just got downgraded to AA+ so maybe things are starting to unravel.

My crystal ball malfunctions all of the time, so I'm not sure when all of this will come to a head.

Common sense suggest that we are getting very close, but I'm not holding my breath.

Anonymous said...

Hi Jim,
The European Union and euro are in big trouble. China is in trouble. Economists state that we're headed for another recession here in the US (what they don't realize is that we are at the beginning of what everyone will come to understand shortly as a depression... so we're not going into a double dip recession, this is just another overall decline within the depression or Great Correction that we are experiencing). The Fed is going to implement massive monetary policy when this next "recession" hits. No matter what the Fed or US Treas does they can't seem to stimulate because the de-leveraging or deflationary pressures are just too damn strong. It is all about the debt. It is too heavy and it has to be defaulted on, there is no other choice. Everyone will still take flight to the USD when the next crisis comes (there is no other place to go).

Are we looking at the possibility that the USD will spike up and gain some serious strength in this next phase of The Great Correction?

I think so. No stocks, bonds or real estate for me as the deflationary pressure are too strong. I'm staying in USD. It appears to be the contrarian strategy to the herd, so there is a good chance that I'm right. There is still time before we have to worry about the USD losing its remaining purchasing power.

Jim in San Marcos said...

Hi Anon 12:40

I agree we are in a depression. As the theme of my blog suggests, it will take a while for that concept to sink in.

I believe that there is a good possibility that our government could come up with a currency exchange involving a reverse split. Something on the order of 10 to 1. You would exchange your old 100 dollar bills for new 10 dollar bills. So being in cash USD might have its drawbacks. It would be a devaluation of sorts. I'll post on that topic when I research it a bit more.

Take care