moneyFYI
Financial Freedom Is Merely Organized Common Sense
Understanding Bonds
A bond is a collection of promises. It is not strictly money but rather, it is an instrument that can be exchanged for money. Probably. Its value at some future time, when you want to change it back into money, is unknown but it will be the sum of the value of the still outstanding promises.
Bonds are a huge share of the investment universe. By comparison the value of the stock market is insignificant. You need to know a little about bonds.
When examining bonds for purposes of investment, you will need to have a reasonable understanding of how “Net Present Value” (NPV) works. You also need to understand that rate of return and thus value is built around many factors.
The principal valuation factors for bonds are the coupon rate on the bond, the market interest rate, the time to maturity, and the underlying security of the assets supporting it or the credit worthiness of the issuer.
For this discussion, because it is difficult to assess and there are way to hedge it, I will assume that there is no credit risk factor.
In the simplest case consider a bond that is due in one year and will pay the principal amount plus a coupon of one year’s interest. There are two promises. The principal and the interest coupon. Let us say $10,000 of principal and $500 of interest. A 5% bond due in 1 year.
If 5% is the same as the interest demanded in the marketplace then the bond will trade for its face value. Here’s why.
The principal today is worth $9,523.81, the amount you would need to invest at 5% to be worth $10,000 a year from now. The $9,523.81 is the Net Present Value of the principal. By the same reasoning, the interest coupon of $500 is worth $476.19 today for a total value of all the promises of $10,000.
If the interest rate in the marketplace is different than the coupon rate then the individual promises are worth a different amount. If the market interest rate is 4% then the 5% bond will be worth more than $10,000. $10,096.15. The extra you pay is the NPV of the extra $100 interest you expect to receive one year from now. (You are getting $500 when the market says you should only get $400)
Longer bonds are more difficult to evaluate this way but the principle is the same. A 25 year bond with annual interest is made up of 26 promises. 25 interest payments and one principal repayment. The only way the bond would have constant market value over the 25 years is if the market interest rate never changes. Pretty unlikely.
A long bond like this one is going to suffer in the marketplace if rates go higher than the rates at which it was issued. At 4% yield, the $10,000 due in 25 years has a present value of $3,751.17 with the NPV of the 25 coupons making up the difference. But if market rates become 8% before maturity, the NPV of the bond, what you can sell it for, will be greatly reduced. For example at year 10, the 4% value of the principal is $5,553, and the coupons are worth $4,447. At 8%, the principal is only worth $3,152 and the coupons are worth another $3,424. for a market value of $6,576. Lose nearly 35% of the purchase price.
You can find these value using a spreadsheet and the net present value function.
Interesting, but what does it mean?
Given that rates are very low now, it means that you can lose a lot of money owning long bonds and you cannot expect much increase in value because you can only win if rates fall.
Owning long bonds now is a game with the following rules:
- You can breakeven if rates don’t change.
- You can win if they fall, but you are likely to only win a little because there is not much room to fall. Unless you believe they could become negative.
- You can lose a lot if rates rise.
Your proper strategy: Refuse to play the game. Win small or lose big is never attractive.
If you must play, perhaps because there is nothing better to invest in, be a trader not an investor. Be willing to get out at the first sign of trouble.
Investors often make mistakes because they do not realize that their investments are not money. They are only money after they sell them. The marketplace will put a value on them that may suit you or it may not. When evaluating your risk tolerance, keep in mind that you cannot have money until you sell and that amount is unknown.
Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. don.s@protectorsgroup.com
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