Its Not Your Father’s Bond Market

For many investors, understanding how bonds work is a challenge at the best of times but times are-a-changin and because bonds and fixed income investments are a very important component of most investors’ portfolios, it bears comment, so here goes -

In the “old days”, a government or corporation would “borrow money” by selling bonds to the public who would buy the bonds, receive interest payments and get their money back at maturity, kind of like a CD or term deposit as we call them in Canada.

So for example, ABC Corporation would issue a bond in lots of 1000 (known as $100 par value) dollars per bond to pay interest at 10% annually to mature in 10 years. An investor in the bond would get 100 dollars interest a year and in 10 years, providing ABC Corporation was still in business, receive the 1000 principal investment back on the last day of the 10th year known as the maturity date. Still with me?

Now that the bond has been issued it is traded among investors, kind of like a stock, right up to the date of maturity. (Lets call this the interim market) . Traditional factors that affect the price of the bond  in the interim market are the credit worthiness of the company, the general level of interest rates and how much time is left to the maturity date. The price of the bond will fluctuate from date of issue to the date of maturity to reflect these conditions at any given point in time. Typically bonds prices would move slowly up or down as the market digested news of the day.

To gauge the credit quality of the bond most investors would rely on Credit Rating Agencies, such as Standard & Poors, to “rate” the bond,  AAA being the best rating and lessor quality bonds assigned lower ratings such as AA, BBB or CCC. After all who has the time to dig through every corporation’s financial statements on an ongoing basis. You get the picture.

In general terms “bonds” were always thought of as the “safe” part of ones portfolio because they ranked higher than a corporations stock in the event of bankruptcy, they paid interest and you got your money back at maturity.

So What has changed?  –A case of the tail wagging the dog…

Never ones to miss a money-making opportunity those brilliant financial engineers on Wall Street( Read AIG and crowd) came up with the idea that they could sell an insurance type product called a credit-default swap (CDS) to insure the bondholder against the bond defaulting or in layman’s terms. not being able to pay back the $1000 maturity value on the due date.

So now these CDSs are traded in the market like options and like an option a small amount of money can control and impact the price of large principal amounts.

Hedge Funds, banks and brokers are trading these things like mad and the result is amplified price swings at the speed of light in the pokey old bond market.

Of course these are a form of financial derivative that trade largely unregulated, and has become a playground for hedge funds, speculators and fast money operators.

So what does this mean for you dear bondholder?

Increased volatility in the price of your bonds in the interim market. If you own bonds be prepared for sharp price moves. Up and down. If you did your homework and you are comfortable with the company who issued the bond then don’t worry you will get your interest and your money back at maturity.

This heightened level of volatility creates opportunities for astute bond investors. Even good companies’ bonds are getting kicked around by the CDS market players and with the wide prices swings on a daily basis in this ”new era” so your best friend may be a good bond man.

It really has become a case of the Tail Wagging The Dog.

Read what Alex Trias has to say about the New Normal in the bond markets.

This entry was posted on 15. March 2009 at 19:26 and is filed under Uncategorized. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or trackback from your own site.