Insights & News

August 2015
Investment Strategy

The Bond Conversation

By: J. Michael Martin, Founder and Chairman

Interest rates rise… bond prices fall. Rates go up, prices go down.

Brow furrowed and lips pursed, Ralph tossed the Wall Street Journal aside and pushed back from the breakfast table. His muttered annoyance got the attention of 15-year old, Steve. “What’s the matter, Dad?”

“Oh, last year in my IRA I bought $10,000 of brand new 10-year Treasury bonds paying 1.7%; better than a CD, I thought. But I read this morning that the yield is already up to 2.7%.”

“But, isn’t that good? I mean, higher yield is good, right?”

Ralph, who teaches economics at a nearby state college, managed a slight smile. “Well, son, you see… the world of bonds is a kind of alternate universe, where up is down and down is up.”

“Uh huh,” Steve looked puzzled but attentive.

“When I bought that $10,000 bond, I got a security that says I loaned the U.S. Treasury $10,000 which they’ll give back to me in 10 years. The bond also says I (or anybody I might sell it to) will receive $170 a year (1.7% of the face value) in interest on my loan. So far, so good?”

“Uh huh.”

“But now my bonds are trading in the market at a 2.7% yield to maturity! Those bonds I bought at their face value of $10,000 still pay $170 a year, but anyone can buy them now for $9,210. I lost $790 on a lousy treasury bond!” (Ralph is standing up now and Steve backs up a bit!) “Now I need almost five years’ interest to just break even!

“Wa ho! But why did the price go down, Dad?”

“Every time interest rates change, there seems to be a different reason, Steve. The federal deficit is rising or shrinking, the economy is getting better or worse. This time it’s the expectation that inflation is going up; investors know from history that rising inflation usually makes interest rates rise.

If the Treasury were to issue new 10-year bonds today, they would have to offer 2.7% interest to get anyone to buy them… because that’s what “the market” is demanding. So, $10,000 of new bonds would pay $270 interest every year instead of $170. So if I want to sell my 1.7% bonds, no one would want them… unless I offer them at $9,210… because that’s the price at which $170 of interest for the next 9 years… PLUS the prospect of getting the $10,000 that the Treasury has to cough up in 2023… equals 2.7% a year. You see?”

“Uh, I’ll pay extra attention in algebra today! Gotta go. Bye, Dad.”

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