Bond market trap

Biggest risk to bond holders

It's said that the biggest risk to bond investors is rising interest rates, this is because if you buy a bond with a 10 year maturity which pays a yield of say 4%, then in two years time you want to sell that bond and rates for similar term bonds have risen to 6%, you're going to need to sell your bond at a discount to it's face value to entice a buyer to buy it.

Why?

Who's going to want to buy your 4% bond when they can buy one that pays 6%. This being the case, what will happen to all this long term bond debt the United States Treasury has been issuing lately when interest rates start to rise again?

Yields on 30 year notes are now below 4%, so it's hard to imagine they can get any lower and still remain as an attractive form of investment. Sure, investors like safe investments but they also demand returns and for my money, there is simply too much risk to take on one of these long term bonds at such low rates of return.

Fleeing to the safety of US treasuries

It's only a matter of time before the "Flee to the safety of US Treasury Bonds" line, which is about as see-through as a Paris Hilton party dress, is seen for the bullshit it is and when that time comes the yields will rise and the game will be over.

To start with what's going to happen to the big licks of debt that have been sold at the super cheap rates of the past year and a bit?

It's all going to need to be sold at a huge discount or held at a shitty rate of return for what will seem like an eternity for the holders. I mean lets face it, who's going to want to hold 30 year bonds at 3.8% if yields were to rise to say 6.9%, think bursting bubbles, think huge discounts to face value.

Sure the Fed will tell you today that they expect rates to be low for an extended period, but their track record on economic predictions is as about as credible as a Goldman Sachs investment advisor trying to sell you something named after an ancient calculator.

Besides have you ever considered the Fed might have a vested interest in putting out that line? What would happen if no-one wanted to buy these trillions of dollars in bonds, how would the US Government raise the cash is desperately needs going forward? What would happen to the US economy and the sale of US Treasuries if people started to question the ability of the US Government to honor it's commitment to repay it's debt? What would happen to the US dollar? More importantly, what will happen to the Fed?

Rising rates

One of two things, if not both are likely. Rates will rise as they always do when the risk is seen to be greater. Then if a higher rate of return isn't enough to entice buyers, there is the real risk of collapse of the US treasury bond market as everyone discounts the existing bonds they hold to dump them on the secondary market.

To understand where I'm coming from, you first need to be clear on how the value of a bond is calculated when sold on the secondary market. Below is a simple back of the envelope calculation, there are a few other factors that need to be considered to get an truly accurate figure but this will serve to give you the general idea.

What's a bond worth on the secondary market?

OK for arguments sake lets work with a $1000 bond for the purpose of this example and lets also assume you paid face value for it, that is you handed over $1000 and for the sake of the calculation we'll also say it's a 30 year bond at 3.80% with interest paid annually just to simplify the whole calculation and demonstrate a worst case scenario. Worst case because the longer the term the greater the discount required.

So based on the above you'll receive interest payments of $38 every year and on maturity you will be handed your $1000 back.

However lets say you hold it for 2 years at which point rates for similar term bonds have risen to say 6.9%.

At this point the same $1000 would purchase a bond that pays $69 every year or $31 more than the bond purchased 2 years earlier.

So to work out how much you need to discount your bill by to sell it you need to multiply the difference ($31) by the years remaining on your bond, 28. So that's 28 x $31 = $868 which is the discount you'd need to apply to your bond to sell it.

$1000 - $868 = $132. Yep you've read that right, your original $1000 has turned into $132 in the space of two years just because rates moved upwards. You might need to re-read that sentence again slowly to take it all in.

So unless you expect either massive deflation and/or a protracted period of really low interest rates you should steer well clear of US treasury bonds at these ridiculously low yields, let someone else pick them up, then buy them from those suckers for a song in a few years time.