The Market Knows Bonds.

It’s fun to watch the bond market continue to climb in price. After all, this is not supposed to happen after a downgrade.

If you’ve never understood bonds, now is a great time. The following is a short, simple but sufficient explanation…

Like we explained last week, a bond is a debt instrument. If you are selling a bond, it means you are looking to borrow money from an investor. The investor is someone who would buy your bond. If you are a highly rated company or entity then you will be able to sell your bond for a low rate of interest. In other words if the seller of the bond is considered to be very strong, then they will be able to lend at a better rate. A lower rate.

Here is where it gets tricky.

Market prices for bonds move every day as investors come in and out of the market. Also, as we have seen, the credit rating of these bond sellers can move as well based on factors having to do with their financial stability.

An entity issuing a bond, however, must fix in the rate of return up front and then take it to the market. It is guaranteeing a rate of interest up front in a moving market.

So how does the market compensate for changes in the desirability of these instruments if the rate is fixed up front? PRICE. Investors will simply pay more or less for the right to achieve the stated bond rate on any given day.

For example, Fannie Mae will often come to the market with $40 billion in bonds at a 4% rate. They set the rate at 4% up front and then they try to sell them. The question is this: at what price are they able to unload these? For a $100 bond there are three options: $100, more than $100 or less than $100.

If the $100 bond sells for $100 even, then the market is saying that 4% is right on. The issuer and the investor are at the same price.

If the $100 bond sells for $98, then the market is saying that this particular bond is not worth 4%. The only investors willing to go in and buy are those who are buying at below face value. In other words they don’t trust the issuer at the risk level of 4%. They are requiring a higher yield – 4% plus 2% on the price of the bond ($2 off the $100 price).

But if the $100 bond sells for $102 or $103, then the purchasers of the bonds are actually saying that they want this investment even if they have to leave some of their profits on the table. They get the 4% rate but are paying $2 or $3 (2% or 3%) more up front to get it.

A higher price on the bond reduces the yield to the investor. It also reduces the cost to the issuer because they were able to sell $100 bonds for more money.

Now here’s the big question: Who knows better—the market or the credit ratings agency—what the price or rate should be for a particular bond issuer?

Judging by the events of the past three business days, the market does.

It’s simple. Since the downgrade of the US bond and the subsequent down grade of the Fannie and Freddie bonds, prices have not declined but have actually risen. This means that investors are even more willing today to buy these bonds than they were last Friday.

Many factors contribute to this, including continued fear on the part of large business to invest in this market as well as the lack of other choices for “safe” investments, but the facts still remain:

  • The market is not predictable.
  • The market values what it values; in this case it see the US government as very able to pay its bills.
  • All information that is knowable is instantly factored into prices.

Let me give you a helpful analogy. Moving from AAA to AA+ is like your credit score moving from 840 to 820.

Now, if Obama had come to the microphone and said that, I would have felt a lot better.



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