Bonds As A Leading Indicator Of Stocks

The purpose of this article is twofold. One is to demonstrate a strong positive relationship between bonds and stocks. In other words, the price action and technical readings in the two markets should confirm each other. As long as they are moving in the same direction, analysts can say that the two markets are confirming each other and their trends are likely to continue. It's when the two markets begin to trend in opposite directions that analysts should begin to worry.

The second point is that the bond market usually turns first. Near market tops, the bond market will usually turn down first. At market bottoms, the bond market will usually turn up first. Therefore, the technical action of the bond market becomes a leading technical indicator for the stock market.

The young bull market in bonds and stocks continued into early 1983. In May of 1983, however, the bond market suffered a bearish monthly reversal, setting up a potential double top on the bond chart. At the same time, the stochastics oscillator gave a sell signal. Data shows, stocks began to roll over toward the end of 1983 and flashed a stochastics sell signal as the year ended. The setback in stocks wasn't nearly as severe as that in bonds. However, the weakness in bonds warned that it was time to take some profits prior to the 15 percent stock market decline.

In mid-1984 both markets flashed new stochastics buy signals at about the same time. (Bonds actually began to rally a month before stocks.) The beginning of the second bull leg in the bond market had a lot to do with resumption of the bull market in stocks. Both markets rallied together for another two years. It wasn't until early 1987, when the two markets began to move in opposite directions, that another negative divergence was given.

hi April 1987 bonds began to drop (flashing a stochastics sell signal), which set the stage for the 1987 stock market crash in October of that year. Once again the bond market had proven its worth as a leading indicator of stocks. The bullish monthly reversal in bonds in October 1987 also set the stage for the stock market recovery from the 1987 bottom. A stochastics buy signal in bonds at the end of 1987 preceded a similar buy signal in stocks by almost a year. During the entire decade of the 1980s, every significant turn in the stock market was either accompanied by or preceded by a similar turn in the bond market.

Overlay charts will show comparison of the relative action of bonds and stocks over shorter time periods. On the monthly charts used in preceding paragraphs, price breakouts and stochastics buy and sell signals were emphasized. In the overlay charts, attention will shift to relative price action. Price divergences are easier to spot on overlay charts, and the leads and lags between the two markets are more obvious.

Data compares the two markets from 1982 through the third quarter of 1989. The similar trend characteristics of the two markets are more easily seen. The most prominent points of interest on this chart are the simultaneous rallies in 1982; the breakdown in bonds in 1983 leading to a stock market correction; the simultaneous upturn in both markets in 1984; the top in bonds in early 1987, preceding the stock market crash of 1987; and both markets rallying together into 1989. To the upper right it can be seen that the breakout by stocks above their 1987 pre-crash highs has not been confirmed by a similar bullish breakout in bonds.

Data show break the period from 1982 to 1989 into shorter time intervals to provide closer visual comparisons. I'll take a closer look at the events immediately preceding and following the October 1987 stock market crash and will also examine the market events of 1989 in more detail. Data shows the relative action of bonds and stocks at the 1982 major bottom. Notice that as the Dow Industrials hit succeeding lows in March, June, and August of 1982, the bond market was forming rising troughs in the same three months. In August, although both markets rallied together, bonds were the clear leader on the upside.

In May of 1983, bonds formed a prominent double top and began to drop. That bearish divergence led to an intermediate stock market peak at the end of the year, which led to a 15 percent downward correction in the equity market. The downward correction in both markets continued into the summer of 1984. A close inspection of Figure 4.5 will show that the mid-1984 upturn in bonds preceded stocks by almost a month. Both entities then rallied together through the end of 1985. Notice, however, that short-term tops in bonds in the first quarter and summer of 1985 preceded downward corrections in the stock market.

Data compares the two markets during 1986 and 1987. After rising for almost four years, both markets spent 1986 in a consolidation phase. However, at the beginning of 1987, stocks resumed their bull trend. As the chart shows, bonds did not confirm the bullish breakout in stocks. What was even more alarming was the bearish breakdown in bonds in April of 1987 (influenced by a sharp drop in the U.S. dollar and a bullish breakout in the commodity markets). Stocks dipped briefly during the bond selloff. During June the bond market bounced a bit, and stocks resumed the uptrend. However, bonds broke down again in July and August as stocks rallied. You'll notice that bonds broke support at the May lows in August, thereby flashing another bear signal. This bear signal in bonds during August 1987 coincided with the 1987 peak in stocks the same month.

Bonds not only led stocks on the downside in the fall of 1987, they also led stocks on the upside. Figure 4.7 shows the precipitous slide in bond prices which preceded the stock market crash in October 1987. The bearish breakdown in bonds was too serious to be ignored by stock market technicians. However, as the actual stock market crash began, the bond market soared in a flight to quality. Funds pulled out of the stock market in panic were quickly funneled into the relative safety of Treasury bills and Treasury bonds. There was another important factor that helps explain the sharp rally in interest rate futures in October 1987.

In the ensuing panic during the stock market crash, the Federal Reserve flooded the financial system with liquidity in an attempt to calm the markets and cushion the stock market fall. At the time the consensus view was that a serious recession was at hand. As a result the sudden monetary easing pushed interest rates sharply lower. The lowering of interest rate yields pushed up the prices of interest rate futures.

At such times the normal positive relationship of bonds and stocks is temporarily disturbed. Until the markets stabilized, an inverse relationship between the two sectors was evident. However, as Figure 4.7 shows, that inverse relationship was shortlived. In fact, it's remarkable how quickly the positive relationship was resumed. Within a matter of days, the peaks and troughs in bonds and stocks begin to move in the same direction. However, the sharp rally in bonds into the first quarter of 1988 reflected continued concerns about an impending recession (or depression) and the desire on the part of the Federal Reserve Board to lower interest rates to prevent such an eventuality.

By the middle of 1988, things seemed pretty much back to normal. However, through it all, on the downside first and then on the upside, important directional clues about stock market direction during the summer and fall of 1987 could be discovered by monitoring the bond market.

Data gives us a view of 1988 and the first three quarters of 1989. It can be seen that from the spring of 1988 to the fall of 1989, the peaks and troughs in both sectors were closely correlated and that both markets rallied together. However, in this instance the stock market proved to be the stronger of the two. Although both markets moved in the same direction, it wasn't until May of 1989 that bonds finally broke out to the upside to confirm the stock market advance.

Data gives a closer look at 1989. This chart shows the close visual correlation of both markets. The timing of the peaks and troughs is extremely close together. To the upper right, however, the bond market is beginning to show some signs of weakness in what could be the beginning of a negative divergence between the two markets. Read More : Bonds As A Leading Indicator Of Stocks

Technical Analysis Of Commodities And Bonds

The purpose of the preceding exercise was simply to demonstrate the practical application of intermarket analysis. Those readers who are more experienced in technical analysis will no doubt see many more applications that are possible. The message itself is relatively simple. If it can be shown that two markets generally trend in opposite directions, such as the CRB Index and Treasury bonds, that information is extremely valuable to participants in both markets. It isn't my intention to claim that one market always leads the other, but simply to show that knowing what is happening in the commodity sector provides valuable information for the bond market. Conversely, knowing which way the bond market is most likely to trend tells the commodity trader a lot about which way the commodity markets are likely to trend. This type of combined analysis can be performed on monthly, weekly, daily, . and even intraday charts.

THE USE OF RELATIVE-STRENGTH ANALYSIS

There is another technical tool which is especially helpful in comparing bond prices to commodity prices: relative strength, or ratio, analysis. Ratio analysis, where one market is divided by the other, enables us to compare the relative strength between two markets and provides another useful visual method for comparing bonds and the CRB Index.

The upper portion is an overlay chart of the CRB Index and bonds for the three-year period from late 1986 to late 1989. The bottom chart is a ratio of the CRB Index divided by the bond market. When the line is rising, such as during the periods from March to October of 1987 and from March to July of 1988, commodity prices are outperforming bonds, and inflation pressures are intensifying. In this environment financial markets like bonds and stocks are generally under pressure. A major peak in the ratio line in the summer of 1988 marked the top of a two-year rise in the ratio and signaled the peak in inflation pressures. Financial markets strengthened from that point. (Popular inflation gauges such as the Consumer Price Index—CPI—and the Producer Price Index—PPI— didnt peak until early 1989, almost half a year later.)

In mid-1989 the ratio line broke down again from a major sideways pattern and signaled another significant shift in the commodity-bond relationship. The falling ratio line signaled that inflation pressures were waning even more, which was bearish for commodities, and that the pendulum was swinging toward the financial markets. Both bonds and stocks rallied strongly from that point.

THE ROLE OF SHORT-TERM RATES

All interest rates move in the same direction. It would seem, then, that the positive relationship between the CRB Index and long-term bond yields should also apply to shorter-term rates, such as 90-day Treasury bill and Eurodollar rates. Short-term interest rates are more volatile than long-term rates and are more responsive to changes in monetary policy. Attempts by the Federal Reserve Board to fine-tune monetary policy, by increasing or decreasing liquidity in the banking system, are reflected more in short-term rates, such as the overnight Federal funds rate or the 90-day Treasury Bill rate, than in 10-year Treasury note and 30-year bond rates which are more influenced by longer range inflationary expectations. It should come as no surprise then that the CRB Index correlates better with Treasury notes and bonds, with longer maturities, than with Treasury bills, which have much shorter maturities.

Even with this caveat, it's a good idea to keep an eye on what Treasury bill and Eurodollar futures prices are doing. Although movements in these short-term rate markets are much more volatile than those of bonds, turning points in T-bill and Eurodollar futures usually coincide with turning points in bonds and often pinpoint important trend reversals in the latter. When tracking the movement in the Treasury bond market for a good entry point, very often the actual signal can be found in the shorter-term T-bill and Eurodollar markets.

As a rule of thumb, all three markets should be trending in the same direction. It's not a good idea to buy bonds while T-bill and Eurodollar prices are falling. Wait for the T-bill and Eurodollar markets to turn first in the same direction of bonds before initiating a new long position in the bond market. To carry the analysis a step further, if turns in short-term rate futures provide useful clues to turns in bond prices, then short-term rate markets also provide clues to turns in commodity prices, which usually go in the opposite direction.

THE IMPORTANCE OF T-BILL ACTION

One example of how T-bills, T-bonds, and the CRB Index are interrelated can be seen in Figure 3.14. This chart compares the prices of T-bill futures and T-bond futures in the upper chart with the CRB Index in the lower chart from the end of 1987 to late 1989. It can be seen that bonds and bills trend in the same direction and turn at the same time but that T-bill prices swing much more widely than bonds. To the upper left of Figure 3.14, both turned down in March of 1988. This downturn in T-bills and T-bonds coincided with a major upturn in the CRB Index, which rose over 20 percent in the next four months to its final peak in mid-1988.

The bond market hit bottom in August of the same year but was unable to gain much ground. This sideways period in the bond market over the ensuing six months coincided with similar sideways activity in the CRB Index. Treasury bill prices continued to drop sharply into March of 1989. It wasn't until T-bill futures put in a bottom in March of 1989 and broke a tight down trendline that the bond market began to rally seriously. The upward break of a one-year down trendline by T-bill futures two months later in May of 1989 coincided exactly with a major bullish breakout in bond futures. At the same time the CRB was resolving its trading range on the downside by dropping to the lowest level since the spring of the previous year.

In this case, the bullish turnaround in the T-bill market in March of 1989 did two things. It gave the green light to bond bulls to begin buying bonds more aggressively, and it set in motion the eventual bullish breakout in bonds and the bearish breakdown in the CRB Index.

"WATCH EVERYTHING"

The preceding discussion illustrates that important information in the bond market can be found by monitoring the trend action in the T-Bill market. It's another example of looking to a related market for directional clues. To carry this analysis another step, T-Bills and Eurodollars also trend in the same direction. Therefore, when monitoring the short-term rate markets, it's advisable to track both T-Bill and Eurodollar markets to ensure that both of them are confirming each other's actions. Treasury notes, which cover maturities from 2 to 10 years and lie between the maturities of the 90-day T-bills and 30-year bonds on the interest rate yield curve, should also be followed closely for trend indications. In other words, watch everything. You never know where the next clue will come from.

The focus of the previous paragraphs was on the necessity of monitoring all of the interest rate markets from the shorter to the longer range maturities to find clues to interest rate direction. Then that analysis is put into the intermarket picture to see how it fits with our commodity analysis. A bullish forecast in interest rate futures should be accompanied by a bearish forecast on the commodity markets.

Otherwise, something is out of line. This chapter has concentrated on the CRB Index as a proxy for the commodity markets. However, the CRB Index represents a basket of 21 active commodity markets. Some of those markets are important in their own right as inflation indicators and often play a dominant role in the intermarket picture.

' Gold and oil are two markets that are inflation-sensitive and that, at times, can play a decisive role in the intermarket picture. Sometimes the bond market will respond in the opposite direction to any strong trending action by either or both of those two markets. At other times, such as in the spring of 1988, during the worst drought in half a century, the grain markets in Chicago can dominate. It's necessary to monitor activity in each of the commodity markets as well as the CRB Index.

SOME CORRELATION NUMBERS

This work so far has been based on visual comparisons. Statistical analysis appears to confirm what the charts are showing, namely that there is a strong negative correlation between the CRB Index and bond prices. A study prepared by Powers Research, Inc. (Jersey City, NJ 07302), entitled The CRB Index White Paper: An Investigation into Non-Traditional Trading Applications for CRB Index Futures (March, 1988), reported the results of correlation analysis over several time periods between the CRB Index and the other financial sectors. The results showed that over the 10 years from 1978 to 1987, the CRB Index had an 82 percent positive correlation with 10-year Treasury yields with a lead time of four months.

In the five years from 1982 to 1987, the correlation was an even more impressive +92 percent. Besides providing statistical evidence supporting the linkage between the CRB Index and bond yields, the study also suggests that, at least during the time span under study, the CRB Index led turns in bond yields by an average of four months. In a more recent work, the CRB Index Futures Reference Guide (New York Futures Exchange, 1989), correlation comparisons are presented between prices of the CRB Index futures contract and bond futures prices. In this case, since the comparison was made with bond prices instead of bond yields, a negative correlation should have been present. In the period from June 1988 to June 1989, a negative correlation of -91 percent existed between CRB Index futures and bond futures, showing that the negative linkage held up very well during those 12 months.

The 1989 study provided another interesting statistic which takes us to our next step in the intermarket linkage and the subject of the next chapter—the relationship between bonds and stocks. During that same 12-month period, from June 1988 to June 1989, the statistical correlation between bond futures prices and futures prices of the New York Stock Exchange Composite Index was +94 percent. During that 12-month span, bond prices showed a negative 91 percent correlation to commodities and a positive 94 percent correlation to stocks, which demonstrates the fulcrum effect of the bond market.

The numbers also demonstrate why so much importance is placed on the inverse relationship between bonds and the commodity markets. If the commodity markets are linked to bonds and bonds are linked to stocks, then the commodity markets become indirectly linked to stocks through their influence on the bond market. It follows that if stock market traders want to analyze the bond market (and they should), it also becomes necessary to monitor the commodity markets.
Read More : Technical Analysis Of Commodities And Bonds

BONDS AND THE CRB INDEX FROM THE 1987 TURNING POINTS

Data through provide different views of the price action of bonds versus the CRB Index since 1987. Data provides a four-year view of the interaction between bond yields and the CRB Index from the end of 1985 into the second half of 1989. Although not a perfect match it can be seen that both lines generally rose and fell together. Data uses bond prices in place of yields for the same time span. The three major points of interest on this four-year chart are the major peak in bonds and the bottom in the CRB Index in the spring of 1987, the major spike in the CRB Index in mid-1988 (caused by rising grain prices resulting from the midwestern drought in the United States) during which time the bond market remained on the defensive, and finally the rally in the bond market and the accompanying decline in the CRB Index going into the second half of 1989. This chart shows that the inverse relationship between the CRB Index and bonds held up pretty well during that time period.

Data provides a closer view of the 1987 price trends and demonstrates - the inverse relationship between the CRB Index and bond prices during that year. The first half of 1987 saw strong commodity markets and a falling bond market. Going into October the bond market was falling sharply while commodity prices were firming. The strong rebound in bond prices in late-October (reflecting a flight to safety during that month's stock market crash) witnessed a sharp pullback in commodities. Commodities then rallied during November while bonds weakened. In an unusual development both markets then rallied together into early 1988. That situation didn't last long, however.

Data shows that early in January of 1988 bonds rallied sharply into March while the CRB Index sold off sharply, hi March, bonds peaked and continued to drop into August. The March peak in bonds coincided with a major lowpoint in the CRB Index which then rallied sharply into July. Whereas the first quarter of 1988 had seen a firm bond market and falling commodity markets, the spring and early summer saw surging commodity markets and a weak bond market. This surge in the CRB Index was caused mainly by strong grain and soybean markets, which rallied on a severe drought in the midwestern United States, culminating in a major peak in the CRB Index in July. The bond market didn't hit bottom until August, over a month after the CRB Index had peaked out.

Data shows the events from October 1988 to October 1989 and provides a closer look at the way bonds and commodities trended in opposite directions during those 12 months. The period from the fall of 1988 to May of 1989 was a period of indecision in both markets. Both went through a period of consolidation with no clear trend direction. Data shows that even during this period of relative trendlessness, peaks in one market tended to coincide with troughs in the other. The final bottom in the bond market took place during March which coincides with an important peak in the CRB Index.

The most dramatic manifestation of the negative linkage between the two markets during 1989 was the breakdown in the CRB Index during May, which coincided with an upside breakout in bonds during that same month. Notice that to the far right of the chart in Data a rally beginning in the CRB Index during the first week in August 1989 coincided exactly with a pullback in the bond market.

Data turns the picture around and compares the CRB Index to bond yields during that same 12-month period from late 1988 to late 1989. Notice how closely the CRB Index and Treasury bond yields tracked each other during that period of time. The breakdown in the CRB Index in May correctly signaled a new downleg in interest rates.
Read More : BONDS AND THE CRB INDEX FROM THE 1987 TURNING POINTS

The Bond Collapse - A Warning For Stocks

Data compares the action between bonds and stocks in the three-year period prior to October 1987. Since 1982 bonds and stocks had been rallying together. Both markets had undergone a one-year consolidation throughout most of 1986. Early in 1987 stocks began another advance but for the first time in four years, the stock rally was not confirmed by a similar rally in bonds. What made matters worse was the bond market collapse in April 1987 (coinciding with the commodity price rally). At the very least stock traders who were following the course of events in commodities and bonds were warned that something important had changed and that it was time to start worrying about stocks.

What about the long lead time between bonds and stocks? It's true that the stock market peak in August 1987 came four months after the bond market collapse that took place in April. It's also true that there was a lot of money to be made in stocks during those four months (provided the trader exited the stock market on time). However, the action in bonds and commodities warned that it was time to be cautious.

Many traditional stock market indicators gave "sell" signals in advance of the October collapse. Negative divergences were evident in many popular oscillators; several mechanical systems flashed "sell" signals; a Dow Theory sell signal was given the week prior to the October crash. The problem was that many technically oriented traders paid little attention to the bearish signals because many of those signals had often proven unreliable during the previous five years. The action in the commodity and bond markets might have suggested giving more credence to the bearish technical warnings in stocks this time around.

Although the rally in the CRB Index and the collapse in the bond market didn't provide a specific timing signal as to when to take long profits in stocks, there's no question that they provided plenty of time for the stock trader to implement a more defensive strategy. By using intermarket analysis to provide a background that suggested this stock rally was not on solid footing, the technical trader could have monitored various stock market technical indicators with the intention of exiting long positions or taking some appropriate defensive action to protect long profits on the first sign of breakdowns or divergences in those technical indicators.

peaked in August along with the stock market. A second rally failure by the dollar in October and its subsequent plunge coincided almost exactly with the stock market selloff. It seems clear that the plunge in the dollar contributed to the weakness in equities.

Consider the sequence of events going into the fall of 1987. Commodity prices had turned sharply higher, fueling fears of renewed inflation. At the same time interest rates began to soar to double digits. The U.S. dollar, which was attempting to end its two-year bear market, suddenly went into a freefall of its own (fueling even more inflation fears). Is it any wonder, then, that the stock market finally ran into trouble? Given all of the bearish activity in the surrounding markets, it's amazing the stock market held up as well as it did for so long. There were plenty of reasons why stocks should have sold off in late 1987. Most of those reasons, however, were visible in the action of the surrounding markets and not necessarily in the stock market itself.
Read More : The Bond Collapse - A Warning For Stocks

Bond Prices and Yields

The reader will notice that we’ve gotten to this point without specifically addressing the subject of a bond’s yield—that which Inside the Yield Book is presumably all about. A bond’s yield-to-maturity (YTM ) is that discount rate which generates a PV equal to the bond’s price. In our flat world of a single market discount rate, the bond’s price would always be set by that discount rate, so the YTM would always just be this discount rate itself.

One of a bond’s basic attributes is its par value, which (roughly) corresponds to the initial funds received by the issuer. In the most idealized bond with neither call features nor sinking funds, the final “principal payment” at maturity will also be generally equal to this par value. The par value is typically set at $1,000, with the bond’s price and coupon payment then expressed as a percentage of this $1,000 standard. Thus, for a coupon rate that coincides with our fixed market discount rate of 8%, the PV of $1,000 would just match the par value, the price ratio would just be 100% and the bond would be called—not surprisingly—a “par bond.”

For coupon rates higher than the discount rate (generally, for bonds that had been issued earlier during a higher rate environment), the PV would exceed the par value, so the price ratio would be greater than 100%, and such a bond would be called a “premium bond.” Similarly, lower coupon rates and lower PVs would give rise to price ratios below 100%—hence, “discount bonds.”

Now, all this is pretty old hat. Why go through this entire discussion of a flat discount world only to come to these standard descriptions of the three bond types? The point is that these characterizations are really somewhat misleading. All these bonds are fairly priced in the sense that their PV corresponds to their market price. A “discount bond” is not a bargain, nor is a “premium bond” really worth more than a par bond. Only when some differentiating features are incorporated into the analysis does any investment look cheap or dear to a specific investor.

To really understand the YTM, our flat-world assumption must be replaced by the more realistic situation where bond prices are based on a host of differentiating factors such as credit quality, maturity, coupon level, sinking funds, call features, market liquidity, and so forth. In this environment, one can argue about whether the bond’s price or the YTM is the primary determinant of value. The basic fact is that a bond’s price, and its YTM, are defined in a circular fashion.7 Thus, for any given bond, the YTM is the specific discount rate that generates a PV equal to the bond’s market price. Different pricing effects can then also be expressed as different YTMs. Over the years, this YTM approach has proven to be a very convenient comparative yardstick. For example, it has now become commonplace to characterize the incremental return of corporate bonds in terms of their YTM “spread” over the U.S. Treasury bond curve.
Read More : Bond Prices and Yields

Stocks and Bonds: A Primer

First, a quick refresher on stocks and bonds, and then on to mutual funds. What is a stock? Shares of stock are issued by corporations. Buying a stock share means you actually own a piece of a company. Let’s imagine you organized a corporation for the purpose of buying a car wash. You sold one share of common stock apiece to nine people at $100 per share and kept one share for yourself at $100. By doing this, you would have capitalized your corporation at $1,000, and it would have 10 shareholders.

Each shareholder has a partial ownership in your car wash corporation. They took what is called an equity position and will participate in the future gains or losses of the corporation as long as they own shares. If your company has real earnings and a good growth pattern, it will ideally pay the stockholders a dividend, or a share of the profits, over the long term.

In the short term, the price of any stock can be affected by behavior of the market. For instance, an entire sector of the market could be down and, regardless of how healthy that company is, the price of the stock could go down. For example, when the entire tech sector fell out of favor, the price of IBM stock dropped from about $133 a share in August 2000 to about $76 in May 2002. A price of $76 was arguably too low based on an analysis of the solid business IBM was doing. This is a case where movement in an entire sector as well as the entire market affected the price of the stock. In the longer term—a two-to-five-year time span—the price of stock will be determined more by the earnings of the company.

When I think about the lack of predictability of stocks, I’m reminded of some famous advice that the cowboy-turned-philosopher Will Rogers once gave. “Don’t gamble, take all your savings and buy some good stock,” he advised. “Hold it till it goes up, then sell it. If it don’t go up . . . don’t buy it.”1 Will Rogers reminds me that there’s no such thing as a sure bet or a guaranteed rise in stock prices—and helps me keep my sense of humor.

Now let’s examine bonds. A separate and distinct asset class from stocks, bonds are considered debt instruments. They are essentially IOUs to the people investing in them. Remember that car wash corporation that issued stock? Now let’s assume that the car wash also wants to borrow some money.

Instead of going to the bank, it decides to borrow the money from individuals. If it wanted to borrow $100,000 from 10 individuals, it would create 10 bonds worth $10,000 each. In order to attract people who will loan it the money, the company generally has to offer to pay a higher rate of interest than is otherwise available. Since guaranteed bonds issued by the U.S. government may pay about 5.5 percent, your car wash will need to pay bondholders at least, say, 8 percent to encourage people to buy its bonds despite the increased risk a company poses over that of the U.S. government.

People who are going to loan the corporation $10,000 don’t want to wait indefinitely to get their money back. So the car wash decides to have the bonds “mature” in 10 years. That is when the investors will get their money back. The car wash bond investor will essentially be making a loan of $10,000 by buying a 10-year $10,000 bond. Each year the bondholder will be paid interest of 8 percent—$800 a year. The bond is guaranteed by the corporation. As long as the corporation is financially sound, the investors have a reasonable assurance they will get their principal back.

It sounds simple—a guaranteed loan for 10 years at a nice rate of interest. That appears to make it a safer investment than the stock in the same company. But while bonds are considered to be lower on the riskscale than stocks, they are not risk free.

Why? Let’s say in the third year, Uncle John—one of the $10,000 bondholders—gets sick and needs the money. At that point, he will be forced to sell it at the market price. There are a number of variables that determine the price Uncle John will get for his bond. One of the key elements is the relationship between a bond’s interest rate and the interest rate of new bonds in the existing market.

It boils down to this: If interest rates rise above the level at which Uncle John bought his bond, Uncle John will probably get less than the $10,000 he paid if he must sell it before it matures. If interest rates fall, Uncle John may be able to sell his bond at a premium, getting more than he paid for it originally. (This is the old playground teeter-totter analogy: When interest rates go up, existing bond values go down, and when interest rates go down, existing bond values go up.)

Why does it work this way? Say interest rates have gone up from 8 percent to 9 percent. The value of Uncle John’s bond needs to compensate a new investor for the higher yield that he or she could reap from a new $10,000 bond pegged to the higher 9 percent interest rate (which would pay $900 annually) rather than Uncle John’s bond’s 8 percent (which pays $800 annually).

If Uncle John decides to sell his bond at the end of the third year, we know there are seven remaining years when Uncle John’s bond will pay $100 less than what an investor would get from a new bond. So Uncle John may get only about $9,300 for the bond. That’s the original bond price ($10,000) less the loss of $100 in additional interest over seven years ($700).

However, Uncle John could luck out. Let’s say interest rates have fallen to 7 percent and a comparable $10,000 bond yields only $700 a year, or $100 less than Uncle John’s bond pays. In that case Uncle John may be able to sell his bond for somewhere in the neighborhood of $10,700. That’s the original bond price ($10,000) plus $700 to account for the additional $100 in interest Uncle John’s bond will offer over seven years.

Of course we have greatly simplified this matter for illustration purposes. Bond prices are affected by a great many other factors, such as inflation and the length of time to maturity. For example, the longer the time before the new investor can get his or her money back (maturity date), the more the bond is discounted. The bond industry uses voluminous tables and high-tech calculators to sort out all the variables that go into pricing. But what’s important to remember is this: There’s no such thing as a free lunch. There’s also no such thing as a risk-free investment, even in bonds.
Read More : Stocks and Bonds: A Primer

Government Bonds

“What about government bonds?” Linda retorted. “Yes, of course. The safest bonds are issued by the Treasury Department. They’re similar to the securities that the Treasury-only money funds buy, except they’re long-term—up to 30 years. Instead of loaning your money to a company, you’re loaning your money to the U.S. Treasury to finance whatever it is the federal government wants to spend it on. Their rating is higher than triple-A, and they have never been downgraded. They have never failed—and probably never will fail—to pay their interest and principal on time.”

“But can the market price of Treasury bonds go down too?” Gabriel asked. “Yes. They can go down because of the ‘need’ factor I told you about. And all bonds—whether Treasury or corporate—can go down for one other reason.” “What’s that?” “I call it the ‘envy factor.’ ” “Huh?” Linda interjected. “I understood the ‘need factor.’ Fear I also understood. But envy?”

“Let’s say I have put $100,000 into a U.S. Treasury bond that will pay me a fixed 5 percent per year for the next 30 years. How much do I collect in interest each year? The husband replied, “$5,000?” “Right. But now things change. Time goes by, and interest rates go up and up. The Treasury issues new bonds that pay a lot more now, say, 10 percent per year. What happens? I suffer from yield envy—I envy everyone who’s buying the new 10 percent bonds. I say to myself, ‘Darn, if I had only waited, if I had only bought the new bonds paying 10 percent, I could be earning $10,000 per year instead of just $5,000.’ ”

“Tough luck, eh?” interjected Gabriel. “You said it! So one day, I go to you like a used-car salesman and say, ‘Hey, I’ve got this great bond I bought not long ago. Check it out. It’s paying me a nice, respectable income of $5,000 per year, and it’s 100 percent guaranteed by the United States Government.’ If I made that offer to you, would you buy it from me?” Gabriel responded immediately. “You’ve got to be kidding! Why in the heck should I buy your old 5 percent bond when I can get a brand-new 10 percent bond from the Treasury and make double the income?”

“Because I’ll sell it to you cheap.” “How cheap?” “Make me an offer.” Gabriel pondered what might be a fair price. The old bond was paying $5,000 a year. But to get $5,000 a year from a new 10 percent bond, all he’d have to invest right now is $50,000. So he figured that’s what the old bond would be worth—$50,000. “Give it to me for half-price—50 grand. That’s all it’s worth to me.”

The adviser smiled. “Yes, yes. You got it! That’s very close to what the price would actually be in the open market. And that’s also why the market price on existing bonds invariably goes down when prevailing interest rates go up. It’s why rising interest rates are a major threat to everyone who owns bonds. It doesn’t matter who issued the bonds—a rinky-dink company or a Fortune 500 company, a struggling township in a blighted region or the United States Treasury Department—they’re all driven down by rising interest rates across the board.”

Linda was skeptical. “This all sounds very far-fetched. Has it ever really happened before?” “Ohh! Ab-so-lute-ly! In 1980, $10,000 30-year Treasury bonds plunged to $5,500. In 1981, Treasury bonds fell to $4,300. And 1994 was the worst calendar year for bonds in history—all in conjunction with rising interest rates. If you held onto the bonds till maturity, you’d eventually get all your principal back. But in the meantime, you’d be stuck with low yields for years and years.” Linda was despondent. She had come looking for advice on what to buy, but it seemed that all her adviser was doing was giving her advice on what not to buy. She came looking for hope, but it seemed all he could give her was more cause for despair. “You talk all about dangers and disasters,” she said. “Is that all you can see?”

He was pensive, then spoke softly. “You’re forgetting the Treasury-only money funds I told you about. With these funds, your income goes up almost immediately as interest rates rise. The more rates go up, the more you make.”

“Besides,” the adviser continued, “danger is a reality of our time, but even the worst disaster can be an opportunity. It can be an opportunity for you to build your wealth and for the entire country to fix itself. No matter how bad things get, we will survive and, ultimately, thrive.”

“OK, but you even talk about safe investments, like government bonds falling in value. You talk about people selling because of need, fear, envy, and God knows what else. We understand that now. Thank you. But how do we avoid these problems?”

“Just as I told you before. You loan your money only to those who are truly trustworthy, who spend the money wisely, who can almost surely pay back. That takes care of most of the problem right from the outset. Then, to take care of the other problems, you only trust them for a short period of time. For example, instead of lending your money for 30 years, you do it for just 3 years, or 1 year, or even just 3 months. The shorter the period, the less the risk of price fluctuations. If the initial term is from 10 to 30 years, it’s called a ‘bond.’ If it’s between 1 and 10 years, it’s called a ‘note.’ Anything under a year from the U.S. Treasury is called a ‘bill.’ The safest of them all is the Treasury bill, which takes us back to the Treasury-only funds. That’s essentially all they invest in.”

“But you said their rates are horrendously low right now!” “Yes. But what do you prefer—a low guaranteed yield on Treasury bills or huge losses on common stocks?” “Low yield, of course. But we can’t sit around in low yields forever. What could push them back up?”
Read More : Government Bonds

Corporate Bonds

 The couple liked all the advantages, but the whole business about dirt-cheap yields was potentially a deal-breaker. Gabriel seemed much more concerned with safety, while Linda wanted to pursue and explore various ways of getting at least a halfway decent yield. It was one thing to park the funds in a money market temporarily. But to leave substantial amounts there for long periods of time? It seemed like a waste.

“What about corporate bonds,” Linda asked. “Are they safe?” “Not always,” said the adviser. “Sometimes they can be just as risky as common stocks.” “Hold it, please!” interjected the husband. “I’ve heard about stocks and bonds all my life, and I just realized that I don’t understand, in depth, what the heck the difference between them truly is.” “It’s simple. With a corporate bond, instead of buying a share in a company, you are making a loan to the company. Instead of becoming an owner, you become a creditor. Whether the company makes a profit or suffers a loss, it promises to pay your interest every year and give you back your entire principal at the end of the term, just like any loan. In essence, they get your money. You get a piece of paper—the bond certificate—that says they owe you the money.”

“Can you give me an example?” “Sure. Let’s say you buy a $10,000 General Motors 6.75 percent bond maturing in 2028. All that means is that you are making a loan to General Motors for $10,000. GM is promising to pay you 6.75 percent interest per year. They’re also promising to return your principal, in full, in 2028.”

“We get the bonds directly from General Motors?” “No. You get them through a broker, just like a stock. And just like a stock, they fluctuate in price in the market—the bond market. If too many people are trying to buy them, they go up in price. If too many are trying to sell them, they go down in price.” “Why would anyone want to sell them?” Linda asked.

The adviser smiled with respect. These were not dumb questions! “Let’s say you buy a $10,000 bond from a company. Now, instead of $10,000 in the bank, what have you got? You’ve got a piece of paper that says, in effect, ‘IOU $10,000.’ Can you take that IOU to Toys-R-Us and buy your kids a couple of new bikes? If you lose your job, can you use it to pay your mortgage? No. So the first reason anyone might sell a bond is need—because they need the money.

“The second reason,” he continued, “is fear. Let’s say you bought a bond in UCBS. And let’s say, since UCBS is losing so much money, the rating agencies—Moody’s, S&P, and Fitch—downgrade the company. What does that mean? It means all three agencies agree there’s a greater chance than before that this company will default, that it will miss an interest or principal payment.” The adviser paused for a moment to find a way to bring the point home.

“You seem to be the type of people who would never dream of defaulting on your mortgage payments, but believe me, there are big companies defaulting on their bond payments all the time. That’s where the fear comes in. If investors are afraid the company is going to default, they sell. That drives the price down. And if UCBS actually does default, forget it! The value of UCBS bonds can go to 25 cents on the dollar, maybe even down to zero, just like a stock. Their bond is their word, and if they break their word, their bond is next to worthless.”

“That’s hypothetical,” she said with a bit of discomfort as she thought about her father. “Can you give us some real examples?” The adviser bent over to dig a folder out of his lower left file drawer. Within half a minute, he pulled out a big 11- by 17-inch sheet of paper and placed it before the couple, covering the book on safe investments that he had opened in that same spot a few minutes earlier.

On the sheet, hundreds of bonds were shown, all casualties of the tech wreck, the recession, the bankruptcy crisis, or just bad management. They saw Revlon’s 6-year bond, which fell from $975 to $450 following downgrades in ratings. They saw American Airlines’ 2-year bonds, which plunged by nearly half. They also saw bonds issued by Kmart, Lucent, Polaroid, AT&T, Qwest Communications, Electronic Data Systems, and many more—all clobbered in value after downgrades in ratings. “See my point?” the adviser said at last. “A lot of these bonds plunged just like stocks!”


Read More : Corporate Bonds