Bonds...And Rising Interest Rates....

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Submitted by flu on December 7, 2012 - 11:39pm

Ok. So I hate bonds...Because maybe just that I'm an idiot and don't understand them well enough... But to me they seem fakey safe investments... By that I mean, on paper, they seem to look like a safe investment.. Invest X ,get Y% return year over year...But to me they don't seem to be as "safe" as people make them out to be...

What is the ideal economic situation do you make money on a buying bonds?

(Simplifying assumption is that that bond is for a "safe" investment... It's yield is not dependent on credit worthiness of company/institution/etc)....

It seems like the ideal situation would be if you bought a bond that costs $X with yield Y%, and then you have a prevailing interest rate that continues to fall... so that the price of the bond goes up...

So does this mean, in the opposite environment, in which you have a environment where you have a perpetual rising interest rate environment, that the bond value will start to get killed?

If so, why would one want to buy bonds if one anticipates we'll have an environment where interest rates will be rising steadily?

I'll admit, I never bothered to really dig into bonds, beyond just picking an index fund out of a basket of other index funds. And thus far have been lucky....

But curious/inquiring minds now want to know.

Submitted by SD Realtor on December 8, 2012 - 8:12am.

What is the ideal economic situation do you make money on a buying bonds?

Conditions similar to 1980-1984.

Submitted by flu on December 8, 2012 - 9:07am.

SD Realtor wrote:
What is the ideal economic situation do you make money on a buying bonds?

Conditions similar to 1980-1984.

So from what I recall, 1970's was a period of high inflation. And early 80ies was a period of falling interest rates...

So with that, aren't we in a period right now with falling rates (albeit artificially created), and does that at least partly explain why bonds have been doing pretty well in their returns since the price of bonds have been increasing?

And if so, if one expect rates in the near-mid future to start to rise aggressively and continue to rise, wouldn't that make bonds a really really really bad investment in the coming years?

I keep seeing people say that with rising interest rates, the RE market property value is gonna fall...We've been through periods of high inflation and high interest rates in the past...Have we seen huge corrections in RE as a result of rising interest rates (minus the liar loan/bubble periods)?
It seems like there are so many variables when it comes to property, and the value is less correlated to rising interest rates, historically speaking...

On the other hand it seems like there is much higher correlation between rising interest rates and bonds, and that bonds will get slaughtered during a period of increasing interest rates...

Thoughts?

Submitted by SK in CV on December 8, 2012 - 9:07am.

SD Realtor wrote:
What is the ideal economic situation do you make money on a buying bonds?

Conditions similar to 1980-1984.

Yes. Buy at the end of 1980 and sell at the end of 2008. And short right before the fed realizes it can't protect bond holders from inflation forever. I have no idea when that will be.

Submitted by flu on December 8, 2012 - 9:09am.

SK in CV wrote:
SD Realtor wrote:
What is the ideal economic situation do you make money on a buying bonds?

Conditions similar to 1980-1984.

Yes. Buy at the end of 1980 and sell at the end of 2008. And short right before the fed realizes it can't protect bond holders from inflation forever. I have no idea when that will be.

You can short bonds? (Not saying I'm gonna do it. Just curious)

Submitted by SK in CV on December 8, 2012 - 9:22am.

flu wrote:
SK in CV wrote:
SD Realtor wrote:
What is the ideal economic situation do you make money on a buying bonds?

Conditions similar to 1980-1984.

Yes. Buy at the end of 1980 and sell at the end of 2008. And short right before the fed realizes it can't protect bond holders from inflation forever. I have no idea when that will be.

You can short bonds? (Not saying I'm gonna do it. Just curious)

Yeah, a few different ways. The simplest would be plays using ETFs. TLT is a straight bond fund that can be optioned. Or TBT is an ultra short (2x i think?) fund. Or you can even sell puts or buy calls on it. Be careful with that one. You're trading a product that's already a double inverse fund. So if you think the market is gonna tank, you want to go long on it. Don't wanna get caught being right, but trading wrong.

Submitted by SD Realtor on December 8, 2012 - 9:32pm.

Yes you can short them with the vehicles that SK made note of. However you more then likely get killed because those etfs hammer you. Your movement is only from opening to closing. When gaps happen overnight you do not benefit.

***********************

Look at the tnx from 79 to 84. Just think how life would have been if you bought 30 year bonds at that time?

***********************

FLU you spoke of buying bonds. If you meant trading bonds that is an entirely different matter. Talk to Chris, the email I sent you, he is a bond trader.

***********************

Some day, I don't know when, I will buy bonds and sit on them for income... At this rate, it looks like that day is far far away. It will come though.

Submitted by CA renter on December 8, 2012 - 11:13pm.

flu wrote:
SD Realtor wrote:
What is the ideal economic situation do you make money on a buying bonds?

Conditions similar to 1980-1984.

So from what I recall, 1970's was a period of high inflation. And early 80ies was a period of falling interest rates...

So with that, aren't we in a period right now with falling rates (albeit artificially created), and does that at least partly explain why bonds have been doing pretty well in their returns since the price of bonds have been increasing?

And if so, if one expect rates in the near-mid future to start to rise aggressively and continue to rise, wouldn't that make bonds a really really really bad investment in the coming years?

I keep seeing people say that with rising interest rates, the RE market property value is gonna fall...We've been through periods of high inflation and high interest rates in the past...Have we seen huge corrections in RE as a result of rising interest rates (minus the liar loan/bubble periods)?
It seems like there are so many variables when it comes to property, and the value is less correlated to rising interest rates, historically speaking...

On the other hand it seems like there is much higher correlation between rising interest rates and bonds, and that bonds will get slaughtered during a period of increasing interest rates...

Thoughts?

Correct, you want to be buying bonds when rates are high and about to fall. That makes the value of your bonds go up because the higher yield of your bonds (relative to lower yields in the future) will command a premium. You get asset appreciation (price of the bonds you hold), and it's very, very nice to be getting say 10% yields when everyone else is getting 5% yields.

IMHO, during periods of ZIRP, you should be getting ready to short bonds, but you can also get killed if your timing isn't right, depending on how you do it and your time-frame for holding the bonds. Personally, I would love to short bonds, but the Fed is making the timing of that very difficult.

Whoever gets the timing right will be very lucky because they can get the return on their short positions, and then buy assets when rates are high (and prices of those assets are low). There is not always a 1:1 correlation between interest rates and asset prices (like houses), but that's because there are many other variables in play. In the 70s and 80s, you had women entering the workforce en masse, and Baby Boomers were entering their peak buying years. This pushed the prices of assets up even though interest rates were rising. We are on the opposite end of that situation now, though, which is why I am a deflationist...while also acknowledging the potential for a currency crisis of sorts.

If you can hold all other variables constant, then asset prices -- especially those that are dependent on credit, like houses -- would fall when rates rise. If you doubt this, ask yourself why the Fed has been hammering rates down during the entire housing/credit bubble bust.

Submitted by flu on December 8, 2012 - 11:43pm.

CA renter wrote:

If you can hold all other variables constant, then asset prices -- especially those that are dependent on credit, like houses -- would fall when rates rise. If you doubt this, ask yourself why the Fed has been hammering rates down during the entire housing/credit bubble bust.

Um... historical data doesn't seem to support this...Between late 70ies to mid 80ies, didn't interest rates rise from roughly 9% to 18%? But during that period, home prices gained 30%....

Any financial gurus can offer an explanation?

Submitted by SD Realtor on December 8, 2012 - 11:41pm.

Pretty much yes what you said is true. However most bond holders (not traders) don't purchase them for appreciation, but rather income. The simple intent is to hold them to maturity and collect the income. That is why you hear about retirees purchasing them.

In a free market yes I would agree with you. I am sure you have heard many a pundit talk about that bond bubble we are in. Many consider this to be the final bubble, that is, when (not if) this bubble pops there will be hell to pay. As you know the market is anything but free and as we saw in Japan, rates can be kept low a pretty damn long time.

Like I said, the reverse ETFs offered give you the opportunity to be a bond bear but they don't operate as much in your favor as you think they would.

Submitted by flu on December 8, 2012 - 11:47pm.

So it sounds like the worst thing one can do is holding stuff in cash like 1% CD and just waiting 5,10,15+years.

Submitted by CA renter on December 9, 2012 - 2:30am.

flu wrote:
CA renter wrote:

If you can hold all other variables constant, then asset prices -- especially those that are dependent on credit, like houses -- would fall when rates rise. If you doubt this, ask yourself why the Fed has been hammering rates down during the entire housing/credit bubble bust.

Um... historical data doesn't seem to support this...Between late 70ies to mid 80ies, didn't interest rates rise from roughly 9% to 18%? But during that period, home prices gained 30%....

Any financial gurus can offer an explanation?

It was in my post, above:

CA renter wrote:

There is not always a 1:1 correlation between interest rates and asset prices (like houses), but that's because there are many other variables in play. In the 70s and 80s, you had women entering the workforce en masse, and Baby Boomers were entering their peak buying years. This pushed the prices of assets up even though interest rates were rising. We are on the opposite end of that situation now, though, which is why I am a deflationist...while also acknowledging the potential for a currency crisis of sorts.

Those "other variables" were not held constant.

Submitted by CA renter on December 9, 2012 - 3:20am.

Something else to consider:

--------
"A decision by the Federal Reserve to expand its bond buying next week is likely to prompt policy makers to rewrite their 18-month-old blueprint for an exit from record monetary stimulus.

Under the exit strategy, the Fed would start selling bonds in mid-2015 in a bid to return its holdings to pre-crisis proportions in two to three years. An accelerated buildup of assets would also mean a faster pace of sales when the time comes to exit -- increasing the risk that a jump in interest rates would crush the economic recovery.

“There is certainly an issue about unwinding the balance sheet” in a way that “is effective and continues to support the recovery without creating inflation,” St. Louis Fed Bank President James Bullard said in an interview in October. The central bank might have to “revisit” the 2011 strategy, he added.

The Fed is already buying $40 billion a month in mortgage- backed securities to boost the economy, and policy makers meeting Dec. 11-12 will consider whether to purchase more assets. John Williams, president of the San Francisco Fed, has proposed adding $45 billion of Treasury securities a month.

The bigger the balance sheet, “the riskier the exit becomes,” Richmond Fed President Jeffrey Lacker said during a Nov. 20 speech in New York. “That is something we need to think carefully about.”

Krishna Memani, director of fixed income at OppenheimerFunds Inc., said a too-rapid sale of assets risks disrupting the $5.2 trillion market for agency mortgage debt."

http://www.bloomberg.com/news/2012-12-07...

Submitted by EconProf on December 9, 2012 - 9:09am.

Historically, rapid increases in the money supply and generally liberal fiscal policy combined with stimulative monetary policy has resulted in inflation. This inflation prompts higher interest rates, which causes the market prices of existing bonds (with their fixed interest rates) to fall.
We've now had many years of such monetary and fiscal stimulus and yet have low inflation and still-falling interest rates. Do the old rules no longer apply? Or do they just not apply yet, and will some day hit us with a vengence?
I've been wrong myself in predicting a return of inflation and rising interest rates, so am giving up on predictions.
The old rule about the time lag between a change in monetary policy and the resulting impact on the real economy--whether to tighter or looser--was about eighteen months. Well, that rule is certainly out the window.
It appears that other forces that affect inflation, interest rates, and expectations are overwhelming the stimulative effect of easy money: The deep recession, deleveraging, and especially the economic weakness of the rest of the world making the dollar look relatively safe.
For those of you who believe inflation will result eventually, shorting bonds is one way to put your money where your beliefs are.

Submitted by SD Realtor on December 9, 2012 - 9:17am.

"So it sounds like the worst thing one can do is holding stuff in cash like 1% CD and just waiting 5,10,15+years"

Tough call man. Obviously we are careening down an icy road with no brakes. Monetizing our own debt... it is all a recipe for disaster.

In part the flip problem we have is due to the fact that there are no returns available. When we did our flips we had a 20% target. We got out when our last deal yielded 7 or 8%. Now I see guys happy with 5% as a target! They have groups of people who are happy with that as well.

There is no place for the money to go. Can't buy bonds... These days to make money on equities you have to be good at that rigged game. Returns on flips are tough now. Rentals are okay but you need to find the right market. Precious metals... maybe but I don't know.

I don't have an answer for ya dude. These are uncharted waters for sure.

Submitted by SD Realtor on December 9, 2012 - 9:19am.

Well stated Econ... I agree 100%... My problem is I have been predicting just what you said for like 8 years or so... You know the saying in Vegas right? House rules, house wins. Seems like that has been the working model for the last decade.

I know someday it will catch up and it will be a pretty damn hard crash and burn... just don't know when.

Submitted by SK in CV on December 9, 2012 - 9:57am.

EconProf wrote:
Historically, rapid increases in the money supply and generally liberal fiscal policy combined with stimulative monetary policy has resulted in inflation. This inflation prompts higher interest rates, which causes the market prices of existing bonds (with their fixed interest rates) to fall.
We've now had many years of such monetary and fiscal stimulus and yet have low inflation and still-falling interest rates. Do the old rules no longer apply? Or do they just not apply yet, and will some day hit us with a vengence?
I've been wrong myself in predicting a return of inflation and rising interest rates, so am giving up on predictions.
The old rule about the time lag between a change in monetary policy and the resulting impact on the real economy--whether to tighter or looser--was about eighteen months. Well, that rule is certainly out the window.
It appears that other forces that affect inflation, interest rates, and expectations are overwhelming the stimulative effect of easy money: The deep recession, deleveraging, and especially the economic weakness of the rest of the world making the dollar look relatively safe.
For those of you who believe inflation will result eventually, shorting bonds is one way to put your money where your beliefs are.

We are kind of in uncharted waters. Predictions of high inflation are pretty consistent with most economics theories. I'm no particular fan of the federal reserve bank, but their actions over the last 30 years have been pretty masterful. We can pretty much forget what their stated mission is, they've had mixed results in doing what they're theoretically supposed to do. But forget what they're supposed to do. Their real mission is to protect their member banks. And the biggest threat to member banks is inflation.

Banks are debt holders. That's what they do. They nickel and dime us for services but they make their money by the spread between what money costs them to rent and what they earn by lending it out. Banks bear the risk of inflation. It is their achilles heal. High inflation will kill them. So the fed will protect against it all costs. The byproduct of their unpredictable and resounding success is wage stagnation. I really have no idea if that was the plan. Maybe it was not just the byproduct. But it is the result.

The next step is problematic. If we do see wage inflation, the fed will jack up interest rates. If interest rates go up, the value of long term debt falls, and banks suffer. So the fed has to walk a tight-rope. Their actions will cause damage to their primary protectorate (the banks, not the conomoy as a whole), so as to prevent even greater damage that higher inflation will cause.

No predictions. I'm just convinced that the fed will do what it can to protect banks above all else. Which means they will do whatever they can to reduce the risk of bonds collapsing.

Submitted by EconProf on December 9, 2012 - 10:09am.

There is another way to place your bets on a rapidly rising inflation rate...some day. And it is a route available to most Piggs: Take out a 30-year fixed rate loan at today's rates. Get it ASAP, and for as much house as you can afford. You will be in an appreciating asset while paying for it with increasingly worthless dollars.
The rule of 70 tells us how long it will take for principal to double when increased at a fixed percent each year, compounded. Thus, a 10% increase annually will double in seven years. (Plug in your own expected inflation rates here). Meanwhile, if your pay increases at the rate of inflation (a big if--could be more, could be less), then in seven years the pain of that monthly mortgage payment will be half of what it is today. Voila, house value doubled, monthly cost halved.
The downside: you will have to live with the guilt that you've impoverished that Chase or B of A or Wells Fargo bank that was foolish enough to make that loan. Expect many sleepness nights.

Submitted by flu on December 9, 2012 - 11:17am.

I was talking to my parents just a few minutes ago. Back in 79-80 when they were buying houses in SoCal... The prevailing fixed rate mortgage was 14.75%....Borrowing $150k cost $1866/month.

But at the time banks were doing 5 year CD's at 18%....

Couldn't figure that one out.

Submitted by SD Realtor on December 9, 2012 - 1:44pm.

Agreed SK... definitely uncharted and well stated with the strategy employed by the Fed.

Submitted by EconProf on December 9, 2012 - 1:51pm.

It all boils down to inflationary expectations. Back then we were looking at a hyperbolic graph of inflation that showed every sign of turning into hyperinflation. Inflation in the 1950's probably averaged 2%. In the 60's it steadily rose from 1-2% in the early years to about 5% by the end of the decade. The 70's saw a steady rise to 13.5% in 1980.
By all appearances the wheels were coming off the economy. Lenders had been burned so badly they adjusted their interest rates upward, assuming the climb in inflation would continue. Homeowners with fixed rate mortgages benefited throughout the 1970s, especially toward the end of the decade, as their values rose and monthly payments stayed constant. Gold hit $800.
It took newly appointed Fed Chairman Paul Volcker to end it all. He took the punch bowl away with a tight monetary policy that threw the economy into a deep recession that tamed inflation and lowered inflationary expectations of all parties.

Submitted by AN on December 9, 2012 - 1:56pm.

flu wrote:
I was talking to my parents just a few minutes ago. Back in 79-80 when they were buying houses in SoCal... The prevailing fixed rate mortgage was 14.75%....Borrowing $150k cost $1866/month.

But at the time banks were doing 5 year CD's at 18%....

Couldn't figure that one out.


Can you imagine getting 30 years CD in the teens %? Will we see that again in the next decade?

Submitted by flu on December 9, 2012 - 2:32pm.

EconProf wrote:
It all boils down to inflationary expectations. Back then we were looking at a hyperbolic graph of inflation that showed every sign of turning into hyperinflation. Inflation in the 1950's probably averaged 2%. In the 60's it steadily rose from 1-2% in the early years to about 5% by the end of the decade. The 70's saw a steady rise to 13.5% in 1980.
By all appearances the wheels were coming off the economy. Lenders had been burned so badly they adjusted their interest rates upward, assuming the climb in inflation would continue. Homeowners with fixed rate mortgages benefited throughout the 1970s, especially toward the end of the decade, as their values rose and monthly payments stayed constant. Gold hit $800.
It took newly appointed Fed Chairman Paul Volcker to end it all. He took the punch bowl away with a tight monetary policy that threw the economy into a deep recession that tamed inflation and lowered inflationary expectations of all parties.

...None of which anyone is willing to do these days....Things are gonna end badly for this country, ain't it?

Submitted by no_such_reality on December 9, 2012 - 3:25pm.

flu wrote:
CA renter wrote:

If you can hold all other variables constant, then asset prices -- especially those that are dependent on credit, like houses -- would fall when rates rise. If you doubt this, ask yourself why the Fed has been hammering rates down during the entire housing/credit bubble bust.

Um... historical data doesn't seem to support this...Between late 70ies to mid 80ies, didn't interest rates rise from roughly 9% to 18%? But during that period, home prices gained 30%....

Any financial gurus can offer an explanation?

Inflation in that period was about twice that. Seriously 65% from 1978 to 1985. '77 t '84 was 75%. And it was 50% from 1975 to 1980.

Submitted by barnaby33 on December 9, 2012 - 4:32pm.

However most bond holders (not traders) don't purchase them for appreciation, but rather income.

Depends on the investor. I doubt China buys UST debt for the income.

As with everything else said in this thread there are more caveats than certainties.

Least certain of all is the availability of a personality that can see the switch and react accordingly. I made money hand over fist in 2008, when everyone else was losing it. However I just didn't believe in a turn around. I thought people were smarter than that. I was wrong.
Josh

Submitted by SD Realtor on December 9, 2012 - 6:59pm.

I would be very interest to see how much of our debt is being purchased by other entities, (private parties, other countries, etc...) verses how much we now monetize.

Also regarding inflation, don't think for a minute we have not experienced inflation over the past few years. Look at prices of food, water, and energy.

*********

AN I also dream about the days of high rates to buy bonds. However with those days we saw inflation and mortgage rates that would make you cry. Not to mention credit for business loans. Not fun times man.

Submitted by AN on December 10, 2012 - 2:14am.

SD Realtor wrote:
AN I also dream about the days of high rates to buy bonds. However with those days we saw inflation and mortgage rates that would make you cry. Not to mention credit for business loans. Not fun times man.
As long as it doesn't turn into hyperinflation where I'd have to cart around a wheel barrel to buy a loaf of bread, then I think I'm better off with high inflation vs high deflation (based on my calculation and assumptions). Just look at past data: http://www.census.gov/hhes/www/housing/c..., look where CA housing price was in 1970 and where it was in 1980. Not adjusted for inflation, it went from $23,100 to $84,500 in just 10 years. I can only dream we'll see that again. If history repeats itself and we'll see the 70s/80s again, can you imagine back then buying a couple of median priced houses in 1970 and selling in 1980 for over 3.5x more? Then take that $150k gain and buy a 30 years CD in the mid teens? If you put $150k in a 30 years CD making 15%, that $150k will be about $9.9M today.

Just for fun, I ran the scenario I just described above but use today's housing price instead. Lets assume you have 2 houses that averages out to be $350k/house. If price goes up 3.5x, those two houses will be worth ~$2.45M. If you then put that in a 30 years CD making 15%, that $2.45M will be at $162M after 30 years. Man, old folks seems have all the luck. Hopefully us Gen X/Y will get to see some of that luck someday soon.

Submitted by CA renter on December 10, 2012 - 3:14am.

AN,

You're right that timing is everything, and those who came before us were in a very different position than we are. Still, trees don't grow to the sky, and we have serious wage constraints that will affect us for generations to come, IMHO.

Personally, I think we are in definite bubble territory for the very reasons that SDR stated above. All the wealth in the world is traveling the globe looking for any kind of yield. When investors are celebrating a 5% return on assets that just experienced one of the greatest bubbles in history (both housing and credit), you know you have a problem. Low interest rates and loose monetary policy is what got us into this mess, and they are only making it worse with ZIRP...with no end in sight. The Fed is killing us (especially savers and people on fixed incomes); we are all gamblers now.

Submitted by bearishgurl on December 10, 2012 - 9:01am.

AN wrote:
. . . Just for fun, I ran the scenario I just described above but use today's housing price instead. Lets assume you have 2 houses that averages out to be $350k/house. If price goes up 3.5x, those two houses will be worth ~$2.45M. If you then put that in a 30 years CD making 15%, that $2.45M will be at $162M after 30 years. Man, old folks seems have all the luck. Hopefully us Gen X/Y will get to see some of that luck someday soon.

AN, most "old folks" ahem (if you mean boomers), were likely raising families in 1980 (like you are now). They couldn't sell their home to buy bonds because they (and their families) were living in it. Very few owned rental homes as well, and if they did, they had mortgages on them and so had little profit to spare every month which had to be saved for vacancies and repairs. And many of the WWII Gen and Greatest Gen before them who WERE invested in these high-interest bonds (because their homes were paid off) had to LIVE OFF of their bond income and pay for board and care, nursing homes and even hospice with it. Medical insurance plans back then did not cover such things and SS payments and even government pensions were nowhere near what they are today.

Your "pie-in-the-sky" scenario likely only applied to a few of the "rich" at the time ... who had perfect timing. It did not generally apply to joe6p..

Due to changes in labor law over the last 2-3 decades and greater access to money for higher education, more of your generation (Gen Y?) has FAR greater earning power and FAR better working conditions than ANY generation before it. The reason why most of your brethren don't have as many assets at the same age as your predecessors did is because your generation (and to a large extent, Gen X) has a much higher expectation of standard of living than boomers did and so most of you spend your money every month to achieve that instead of save it. Many, many Gen Y are saddled with higher-interest student loans, as well, so that "greater access to money for higher education" has proven to be a two-edged sword for many :-0

Submitted by no_such_reality on December 10, 2012 - 9:26am.

Loans for college should be criminalized. It's the worst for usury there is. At least a loan shark is honest about breaking your legs if you can't pay. College loan programs will just indenture you for life.

Seriously, the loan programs to make college 'affordable' has done nothing but skyrocket the costs of college.

Submitted by AN on December 10, 2012 - 11:25am.

BG, I was referring to a couple of rentals, not your primary resident. Secondly, where did I said this is for your joe6p? Your average Joe6p doesn't have a couple of rental properties. Your average joe6p are the renters of these rentals, not the landlord. So, the rest of your argument about student loans, expectation, etc wrt your average gen x/y doesn't apply.

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