Bonds blowing up

Bond prices go down when interest rates rise. For every year of duration until maturity, a bond will lose 1% of its value for every 1% rise in interest rates. A 30 year bond will lose 60% of its value if interest rates rise 2% (30 years X 2%).

The book, “The Price of Time,” describes how almost $18 TRILLION in bonds have been issued internationally with NEGATIVE interest rates. The U.S. did not issue negative yield bonds but the yield fell to 1.5% in 2020 due to the Federal Reserve repression. It is now 3.9% and rising fast.

Global fixed income markets outstanding increased 3.3% Y/Y to $126.9 trillion in 2021, while global long-term fixed income issuance decreased 3.7% to $26.8 trillion.

Global equity market capitalization increased 16.6% Y/Y to $124.4 trillion in 2021, as global equity issuance rose to $1.0 trillion, an increase of 25.6% Y/Y. This shows the impact of the stock market bubble.

The emergency Fed policies suppressed interest rates far below their historical norm, triggering a huge bond bubble. Now that yields are rising to their historical norm, they might stick. That would cause massive losses for bond holders.

by Greg Ip, The Wall Street Journal, 10/14/2022


In the days surrounding the British government’s tax-cut announcement on Sept. 23, yields on British government bonds, called gilts, gyrated as much as 1.27 points in a single day as pension funds dumped bonds and closed out bond-linked derivatives positions to meet margin calls. The Bank of England was forced to step in and buy bonds to stem the selloff

The British bond market debacle might be a sign of similar dynamics at work and another reason to expect structurally higher, more volatile real (inflation-adjusted) interest rates in coming years. …

As investors exit strategies designed to exploit low real rates, they subtract an important source of demand for bonds. They thus compound other factors pushing real rates higher, including more volatile inflation, central bank bond sales and larger government debts…[end quote]

As the Fed continues to raise rates, the USD is strengthening relative to other currencies.

Many middle-income countries’ sovereign debt is denominated in USDs. They will suffer a double whammy of lower values on these bonds coupled with the obligation to pay interest in USDs.

Don’t be surprised if there is a bond market crash to parallel the stock market crash. Many bond strategies are highly leveraged and rely on interest rates continuously falling. (Sound familiar?)

And don’t be surprised if the bond market crash propagates internationally.
Wendy

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AT&T has issued massive quantities of low interest rate bonds. Most of these can be bought back with cash flow

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AT&T probably won’t buy back their bonds with cash flow. They benefit from the low interest payments. It’s the investors who will suffer.

If AT&T had spare cash flow they would probably buy back stock, not bonds. That would increase the earnings per outstanding share of stock – which is a key metric for rewarding company managers.
Wendy

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Wendy,

The times are chang’n. I do not know what ATT will do here but deleveraging would be the smart move. ATT has far too much debt for my blood. The equity would do better if ATT deleveraged.

The investors will only suffer from their poor judgement as to an acceptable return.
They are getting the interest income they signed up for.
Their book value will suffer though.

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I agree with Wendy’s overall concerns and wanted to add a little precision on the bond pricing element.

For every year of duration until maturity, a bond will lose 1% of its value for every 1% rise in interest rates. A 30 year bond will lose 60% of its value if interest rates rise 2% (30 years X 2%). >

This duration “rule” is a estimate, but it’s inexact, and most importantly, it’s not additive. For instance, a bond won’t lose 120% of its value if interest rates rise by 4 percentage points. Losses will be closer to 1- ((1.00- 0.30)^4) = 76%. (The actual number is a bit less because the duration rule loses precision in these extreme cases.)

Also, even more wonkishly, the duration of most 30-year bonds isn’t 30 years. The interest payments you get along the way reduce the overall duration. The duration of a 30-year Treasury with annual 3% payments is just under 20 years.

Here’s a good bond calculator you can use to play with the numbers yourself [I think the link works even though the preview doesn’t]:
https://www.fncalculator.com/financialcalculator?type=bondCalculator

and one to calculate duration:

best,
dan

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BREAKING NEWS**

While borrowing rates have soared, the saver is finally getting something. Just checked CD rates at 5/3. 12 Month promotional CDs are now offering 2.5%. All other maturities of “standard” CDs are still stuck at 0.01%.

Steve

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Good to know.

Showing 1 year CD rate of 3.25%.
Secondary market 1 year CDs are 4% on Fidelity.

Wendy

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Hi Wendy,

Thanks for all your thoughtful comments and sharing the knowledge.

I am new to investing and have made very costly mistakes in the very short time I have been in the market…with significant destruction of capital. But at least I have learned some things (albeit very expensive lessons)…I am now trying to learn more earnestly about markets and investing…

I was hoping if you can expand a bit on these 2 points:

  1. What is secondary market CD and how is this different from the routine CDs that banks like, say Ally, provide?

  2. Similarly, I would greatly appreciate if you could share your thoughts on how the secondary treasury bills in Fidelity are different compared compared to treasury bills bought directly from treasury direct…I ask because I see the T Bills from the treasury direct have different auction dates, but I see a continuous surplus of T- bills in fidelity, although I find it very difficult to understand what is the yield on the secondary bills compared to the primary bills offered by the Treasury direct…I am assuming fidelity would be charging me something for this but when I went to buy, I am not seeing any of the fees come up. For example,

UNITED STATES TREAS BILLS ZERO CPN 0.00000% 02/07/2023 - for a $1000 purchase, it shows I have bought it for $987. So, does that mean my overall profit for this purchase would be $13 if I held this bill till maturity date of 2/7/2023 ( or is there an additional money offered as yield that I would be getting, apart from the $13 ).

Thank you,
Charlie

1 year T-note yields 4.46%, and interest is exempt from Michigan State tax. Better deal than a 12 month CD.

United States Rates & Bonds - Bloomberg

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Charlie, you are asking excellent questions.

What if a person bought a 5 year CD at a bank but then realized that they need the money sooner? If they terminate the CD they could lose up to 18 months of interest (depending on the bank and the length of the CD). They can sell the CD on the secondary market through Fidelity without terminating the CD. Since interest rates have gone up they will probably get less than they originally put into the CD. There is also the fee from selling through the brokerage. (I don’t know how much.)
The owner of the CD will have to calculate which is more to their advantage – terminating the CD or selling it on the secondary market.
As a potential purchaser, you should compare the yield from the brokerage CD with new CDs from banks.

" I see the T Bills from the treasury direct have different auction dates, but I see a continuous surplus of T- bills in fidelity, although I find it very difficult to understand what is the yield on the secondary bills compared to the primary bills offered by the Treasury direct…"

You can buy any newly issued Treasury security on the auction date from either www.treasurydirect.gov or Fidelity by placing your order after bidding is open but before the auction date. Fidelity does not charge a fee for ordering a newly issued Treasury security. Here are the dates.

For example, the Announcement for the 5-year TIPS was 10/13/2022. The auction date is 10/20/2022. I could place an order today. The order would sit until the auction (which is 6 big banks only to set the rate) then the order would execute at the auction rate. Since it is an auction there would be no charge to me.

https://www.treasurydirect.gov/auctions/upcoming/

The secondary bills are similar to the secondary CDs. Someone owned a bill (or bond) and needed the money so they decided to sell. Fidelity charges you $1 per $1,000 for each sale. If you bought $10,000 you would pay Fidelity $10. The bond broker who holds the bond for the seller also takes a cut. (I’m not sure how much.) Your final sales price includes these fees. They aren’t listed separately.

Because it is a zero coupon you would only get the difference between the buying price and the par (face) value on maturity.

If the bill (or bond) had a coupon you would pay for the interest that had already accrued since the prior interest payment. You would receive interest every 6 months until the bond matures. Then you would receive the interest plus the full par value.

When you buy a bond on the secondary market it will have a specific maturity date. You will receive the interest on the bond every 6 months. This is what a bond I just bought looks like.

11 Oct 2022 - purchase date

Account #X…236 YOU BOUGHT FEDL HOME LN MTG CRP SER REFERENCE 0.37500% 04/20/2023 (this is a Federal Home Loan Mortgage bond which matures on April 20, 2023)

(Cash) $-9,839.77 (this is what I paid)
Date 10/11/2022

Symbol 3137EAEQ8 [this is the CUSIP number that identifies the unique security]

Symbol Desc. FEDL HOME LN MTG CRP SER REFERENCE 0.37500% 04/20/2023

Shares $10,000.000 (this is the par value since I bought 10 bonds at $1,000 each)

Price $98.2185 (the par value of the bond is $100.00 so I bought this bond at a discount)

Amount -$9,839.77 (this is what I paid, including the discounted principal plus interest)

Interest $17.92 (since I bought the bond between the interest payment dates, I bought a partial interest payment)

Settlement Date 10/12/2022 [the date the trade was settled]

On 10/20/2022 the bond will pay (0.375% x $10,000 = $37.50) in interest into my account. This is 6 months before its maturity date. I bought the bond between its previous interest date (4/20/2022) and 10/20/2022 so I paid $17.92 to buy the interest owed up to the purchase date.

On April 20, 2023 the bond will mature. My account at Fidelity will automatically be credited with the last interest payment ($37.50) plus the par value of the bond which is $10,000. Since the price was $98.2185, I will receive $9,821.85 for an increase of $178.15 on the principal plus the last interest payment of $37.50.

The equation to calculate the interest on a coupon-bearing bond like this is:
Yield to Maturity = [Annual Interest + {(FV-Price)/Maturity}] / [(FV+Price)/2]

The yield on this bond is 3.83%.

Since this is an individual bond you know exactly what you will receive at maturity. If you sell it before maturity on the open market you would receive more or less, depending upon whether interest rates at the time are higher or lower than now. If rates are rising you would get less. If rates are falling you would get more.

I always hold my bonds to maturity. So I always get the par (face) value of $1,000 per bond. I like this certainty.

The disadvantage of a bond fund is that they are constantly trading bonds. A bond fund does NOT have a maturity date. If interest rates are rising the Net Asset Value (NAV) of a bond fund will drop. You won’t get the full par value the way you would with an individual bond. This is why I do not buy bond funds unless I am confident that rates will drop. For example, I might buy a bond fund in April 2023 if inflation is coming down because the Federal Reserve would probably hold or cut bond yields after that.

The calculations for zero coupon and coupon bonds are different. I have a spreadsheet with a bond ladder where I calculate the interest.

I hope this helps.
Wendy

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Thank you so much Wendy. This is super helpful!!
Thanks a lot.
Charlie

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Considering that brokers are paying about 3% for cash, giving up 18 months of accrued minimal interest should easily be made up for by swapping CD’s for short term bonds or even cash (to deploy when interest rates are higher)

Jeff