Can someone explain this article about bonds to me?

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Hashi
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Can someone explain this article about bonds to me?

Post by Hashi »

http://www.madhedgefundtrader.com/the-b ... started-2/

So in the article it says:
The 30-year Treasury bond suffered horrific losses during the May rout, with yields rocketing from 2.5% to 4%. That means it has already lost its coupon for the year, and then some. Bondholders can expect to receive a long series of rude awakenings when they get their monthly statements.
Don't you want the percentages on bonds to be higher? Surely you would rather a 10% yield to a 1% yield, since you will get more in interest when the bond matures? Or is there something I'm missing here? If the yield is too low, no one would bother investing their money in bonds. Especially if it's a 10 year or 30 year bond.

Can someone explain this?
ggrotz
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Re: Can someone explain this article about bonds to me?

Post by ggrotz »

Hashi wrote:http://www.madhedgefundtrader.com/the-b ... started-2/

So in the article it says:
The 30-year Treasury bond suffered horrific losses during the May rout, with yields rocketing from 2.5% to 4%. That means it has already lost its coupon for the year, and then some. Bondholders can expect to receive a long series of rude awakenings when they get their monthly statements.
Don't you want the percentages on bonds to be higher? Surely you would rather a 10% yield to a 1% yield, since you will get more in interest when the bond matures? Or is there something I'm missing here? If the yield is too low, no one would bother investing their money in bonds. Especially if it's a 10 year or 30 year bond.

Can someone explain this?
Alright. Bonds are basically loans with specific terms and set payouts. The yield is the set payout. Basically if I buy a $1000 bond at 2.5% that means it will yield $25 per year. As your story states, the term is 30 years, so if I hold onto the bond, I can't cash it out and I can't re-negotiate the terms until the 30 years are up and I get my $1000 back. So if the yield rate goes up to 4%, I'm losing out on money I might ordinarily get if I still had my $1000.

Of course, I could sell the bond on the external market. The problem there becomes that since the yield of the bond is smaller than the market yield, I'm going to get people who would rather buy new bonds than buy my old one. Which means, I would have to offer a lower price on the bond to compensate my buyers for what they would lose out on in going into a bond contract themselves. For instance, I might have to sell this bond for $900 to make it worth the same as the new bonds out there (there's a real figure you get if you do math, but I'm not in the mood right now). It will still produce the same 2.5% per year and will still pay back the $1000, but I have to compensate the buyer for buying my bond which only returns $25 a year as opposed to a new bond at $40 per year. If your situation was reversed, and you were holding 4% paper in a 2.5% market, you could demand a premium on your $1000 (it'd be like $1100 or $1200).

In other words, what you're missing is that the terms for each bond is written in stone for the period it entails and does not change as the market changes (typically).
Hashi
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Re: Can someone explain this article about bonds to me?

Post by Hashi »

I find myself most satisfied with this response.
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gamer0004
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Re: Can someone explain this article about bonds to me?

Post by gamer0004 »

It is an excellent explanation.

As to the original article, I would like to point out that there are quite a few people who feel that "inflation = theft", as the article also seems to imply. Especially hardline libertarians think so.
However, the price of bonds in the current period depends on expected future inflation. If I expect inflation to go up in the future, I will want to have a higher coupon bond. This is why a 30 year bond will, under almost all circumstances, have a higher coupon than a 10 year bond, which itself usually has a higher coupon than a 1 year bond or a 1 month bond (check, for example, the US bonds (you can select the US from the drop-down menu)). Over longer periods, future inflation becomes less certain, and hence bonds with a long maturity have higher risk, and hence require a higher coupon (which is similar to interest) to entice people to hold them.

Of course, people may fail to take inflation into account. What's interesting is that if people were that irrational, then clearly the market system would not function well without regulation, and hence a libertarian utopia based on the market system would fail spectacularly. Thinking inflation = theft and thinking government (regulation) is bad and wanting to have completely free markets should be mutually exclusive. It shows how libertarianism is an ideology against government which lacks a logically consistent framework.
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