In January, I asked what would happen if you had a 30 year US government Treasury bond and you wanted your money before 30 years is up. Here is the answer...
Most things in the world are for sale, and bonds are no different. The wild card is the price. Perhaps surprisingly, the bond market is set up to be pretty orderly when determining price. It is not like selling a home, mostly, but just partly. When you sell a home the first thing a real estate agent does is check the prices of homes sold (if ANY right now) in your neighborhood. He figures that most homes in the 'hood are roughly the same. Then he adjusts for amenities. In the end, he does not move the price too much from the 'hood's average price. It is fairly but not totally subjective. We always think our home is worth more because of some special things we have done to it. It is only human to think so. The bond market is not so subjective.
The value of a bond is based on these items:
- Cash flow it makes you
- How long the cash flow lasts
- How safe the cash flow is
- What other similar bonds are paying
- Government regulation
- Will any of the above change
The Math Thing
The real estate agent can guess. The bond buyer has no such luxury. Your bond is a cash flow maker. That's it. How it is priced is an amalgamation of the points above in as mathematical of a fashion as possible. Before your eyes glaze over, let me explain…Let’s cover 1 through 4 all in one swoop.
Assume you have a government bond that pays interest for 30 years at 4%. To buy it, you give the dealer $100,000. You begin receiving your $4,000 annual interest (it actually pays $2,000 every 6 months) for the next 30 years. Let's say that in 2 years you want your money out.
In 2 years you have a 28 year bond. The dealer compares your bond to other 28 year bonds for sale and finds that they are paying only about 3%. Since yours pays 4%, it is worth more than the competition. He will pay you a PREMIUM for your bond since IT pays a premium interest rate. He will pay you enough that when he resells it (net of his service fee for providing a liquid market for your bond) the new buyer will receive net 3% interest based on the price he pays and the annual cash it pays.
He will value it as he should value any cash flow producing mechanism, whether a bond, a rental home, a commercial building, an oil well…whatever. It is worth the value of all the future expected cash flows DISCOUNTED back to today based on how long you have to wait for them and how reliable they are. The longer you have to wait, the bigger the chance of something going wrong. SO, the discount rate reflects this.
Think of the discount rate like this: It is the rate of interest you must earn to compensate you for the use of your money over some time, and also for the chances of something going wrong.Now, add in 5 and 6 Above…
So, General Motors bondholders, who were essentially thrown under the bus by the federal government in the bailout, in hindsight should have required an enormous discount rate to buy those bonds. If they knew in advance what might happen, they would not have bought them. We don’t know in advance, though, which is why what we do is called “investing”. We can only estimate our chances.
In the Real World
In the real world, cash flow management is not as simple as the example. This is why I generally use professional management. They have the staff and facilities to continually reevaluate the credit quality and relative benefits of our choices. Additionally, in the world, there are many instruments that are associated with bonds, but do not act exactly like I exemplified. They are used when conditions like changing interest rates, credit qualities, currency values, or government regulation change the playing field. Often these instruments are used to help lower risk.
The Take Away
Bond portfolios have values that change daily based on many, many factors. They often contain other instruments that can be highly beneficial in limiting our risk and potentially enhancing our return. Professional management provides a double check on our money that an individual investor could not likely do effectively by himself. Reviewing credit quality and other issues that affect bond prices requires a highly trained, professional staff.
Another very important take away is that bonds have values that very according to many triggers in addition to interest rates. Interest rates play a part, but it is wrong to assume they are the only moving part.
Chris
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. Bonds are subject to market and interest rate risk. It sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availability and change in price.
Securities offered through LPL Financial. Member FINRA/SIPC.
