Comment: Thanks Dducks for posting this!

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Thanks Dducks for posting this!

The reason you haven’t got any response is because the average person has no idea what a bond is. Oh they might know that it represents an obligation and the “debt is money” kind of statement, but they really have no clue of the relationship between prices, yield to maturity and interest rates.

For those interested when a bond is issued it is issued with these characteristics:

Face Value is usually ……..$1,000 this is par value and all bond prices are quoted 10% of par, so a $100 dollar price quote you see on CNBC is really a $1000 dollar bond price quote ……and if it’s quoted at $90 it’s a $900 price on the bond or $110 it’s an $1100 price on the bond.

Yield to maturity ……………This is the interest payment made by the issuer to the buyer at time of issue.

Maturity………………………..Number of years the issuer will pay you the interest and then return the face value to you upon maturity…..you are loaning them money.

Interest rates are what is quoted as of today prevailing market rates (well market rate before QE’s….the fed’s used to guide short term rates and the market would set long term rates…..but with the fed in the long term market no one really knows what market rates should be…..it’s all about price…..I have a theory of the destruction of the financial market through inflation……but that is a different discussion)

So… A ten year USG bond with a face value of 1.40% (which happened to be the low point for this cycle….actually historic low for this country if I am not mistaken) will pay the buyer ( and I can’t believe that I haven’t actually looked at this) $14.00 a year in interest…..I can’t believe anyone would loan their money to anyone else for a 1.4 % yield, much less a fine upstanding organization like the USG….but I digress…….so here is the thing and what Dducks is telling you. Because you have a bond with a price of $1000 and a yield of 1.4% what do you think will happen when the Fed gets out of the market and interest rates return to normal?

So go to this YouTube and it will teach you about bond prices and the relationship between prices yield and interest rates.

http://www.youtube.com/watch?v=Qmb8CzZ9B4Y

Now that you have some understanding go to this link and it has a sliding scale where you can input your new knowledge and play with the scale to see how bad things can get.

http://www.smartmoney.com/calculator/bonds/bonds-calculator-...

this is a pretty cool tool.

So here’s what I came up with, At Par for a yield of 1.4% my bond price is 100.
But if rates rise to 2.25% (which they have) the value of my bond has decreased by $75.60, at $14.00 a year from interest it would take me 5.38 years just to get that money back….not even calculating the loss in purchasing power due to inflation.
So here the thing…….let’s say interest rates normalize to 6%.......and no one really knows what normal is anymore because the time value of money has been destroyed by all the QE’s…..but let’s say 6%, what does the look like? A loss of $338.60……or 33.8% on that bond……The reason this is so important is that banks buy up this debt and they used leverage to do it…….and they may only have a few dollars of equity per ten of dollars of debt. Think of it this way……if you have a 50% leverage ratio you could stand a 50% decline in your bond portfolio before you experience any real pain…..like a margin call. If you have a 90% leverage ratio (or a 10% reserve like most banks do) then it will only take a 10% decline of those bonds before you get a margin call……and then the frenzy will start…...because you have to sell to met margin calls...it's all about liquidity at that point……and interest rates could sky rocket.

At 10% the decline in bond price could be over 50%......and that’s the thing…….this is a bubble and no one can predict how it will end …….but the odds are it going to end badly. Have any of you seen the movie “Margin Call”…..it was about a mortgage portfolio and the risk the financial firm took in order to package these mortgages together……..but they were packaging them into ……BONDS!

For those who know this stuff I know I over simplified this……but I was shooting for the basics…….to get some basic understanding out there so it can be discussed…..you don’t have to remind me of convexity, durations, imbedded options and the like…….this was bond pricing 101

"Before we can ever ask how things might go wrong; we must first explain how they could ever go right"

F.A.Hayek