Bond values and interest rates explained
Bond values and interest rates related to government debt (called sovereign bonds) have been featured repeatedly in finance news for months. Headline focus has been eastward on Euro zone countries, such as Italy, which has been challenged with higher interest rates (and repayment) costs for borrowing on its debt.
When uncertainty in bond markets over any government or entitys ability to payback occurs, related bond prices trend downward. Inevitably, the bond market prices the troubled entity debt to sell because investors will demand a big discount to accept this insecurity, not unlike a retail shop marking down clothes or other items to move inventory.
Similarly, safe secure bond investment vehicles will rise in price. Why? What bearing does this bond activity have to do with the small investor?
Understanding the price movement of bonds involves knowing what the investor wants the bonds to do for them: pay a good current interest rate, hold the bonds for the maturity date when the bond principal is paid back, or utilise the bonds on a short-term basis for profits on an active trading market.
Bonds are often touted in the investment world as the safer alternative for those persons uncomfortable owning stocks.
Bond positions in a portfolio have traditionally been allocated for their income producing segment for retirees, as well as having stable, predictable outcome.
Subtract your age from 100, the old saying went, and that is the percentage of your savings that should be invested in bonds. Age 70 means a 70 percent bond allocation while conversely; age 25 is a 25 percent bond allocation or less. Investors close to retirement like boring old bonds with good quality credit ratings, little volatility in price swings, and a decent rate of interest.
This insistence on high credit quality generally means that the interest rate return is low. The formula does not vary: high interest rate, high risk. Low interest rates, lower risk.
Insurance and reinsurance industry utilises bonds very specifically, in a carefully defined way.
The industry seeks to match the bond, its maturity date, credit rating and income producing capability against customer liabilities (future insurance redemptions and settlements) that are carried on the companies balance sheets.
When you think about the insurance industry process — a life insurance, or property casualty protection policy is sold. The insurance company collects the premium — in advance — preparing to preserve that cash until a catastrophic event occur, if at all.
If no casualty event happens in the specific time frame (say one year), then no payment; the company keeps the premium.
Until that time, however, the cash premium is restricted but must earn a return for the company to compensate for covering the risk of uncertain losses. Bond choices made by an insurance company for covering these premium liabilities may be different than for small investors, however, you can bet it is still a fairly conservative option.
Bonds are also sold and bought routinely by governments.
Government bond cash proceeds are used to manage money flows in a country, support infrastructure and benefit programs — always with the provision that the investor will receive the amount of principal that he/she loaned to government back.
The US government under the guidance of the US Federal Reserve recently announced an easing in monetary policy in order to continue to mobilise the economy. They will buy US agency bond debt from investors, placing additional cash into the US economic system.
The highest confidence index (and bond credit ratings) is given to the most stable successful economies — those that demonstrate continuously that they are capable of generating a return on investment.
What happens to bond and stock markets when a government economic(s) plan stumbles and its bonds are perceived as lower credit quality?
Various Eurozone countries have been struggling with the global recessionary effects on their economies with lower productivity, fewer jobs, diminishing government revenues while some governments are also mired in billions of Euros of debt.
On September 6, 2012, the European Central Bank (ECB) under the auspices of President Mario, referred to as Super Mario in the press, announced a government bond buying programme in support of these economies. US and European stock markets moved sharply upward in reaction to the announcement the end of last week.
What do headlines mean when it states that the sovereign debt of Italy, for instance, showed bond interest yields increasing, until the ECB support plan was announced?
Then, in what is considered a positive signal, yields started to decrease. How is the man on the street supposed to interpret that statement when considering bond investments?
Its a function of maths!
Next, we explore types of bonds, where to buy them, how to hold them and what happens if you decide to sell.
Martha Harris Myron, CPA PFS CFP (USA) TEP is Director of Tax Services at Patterson Partners Ltd providing integrated cross-border tax, estate, investment advisory and related strategic planning services through entities in Bermuda and the United States. She is a member of the American Citizens Abroad Professional Tax Advisory Council. For additional information, please contact firstname.lastname@example.org or call 296 3528 http://www.patterson-partners.com.
Butterfield wins May 24
MAY 24 MARATHON DERBY RESULTS
Tyler Butterfield wins 24 May Half Marathon
Hoey springs Derby surprise
Dominique dominates again
Sherlock and Swan turn back the clock
Summers here ... let the action begin
Cup results demonstrate crickets demise
Butterfield wins May 24
Contest makes clean sweep
Take Our Poll