What Happens to Bond Prices when Interest Rates Go Up?

When interest rates go up, prices for bonds and bond funds fall and vice versa.  The following examples show the relationship between bond prices and rates.

 

Municipalities and corporations sell bonds for financing.  The issuer who sells the bond pays the buyer interest while the bond is outstanding, and then pays the principal back when the bond is due, that is, when it matures. 

 

The price of the bond is fixed, as far as the issuer is concerned.  If the company sells a $1,000 bond with a 5% interest rate to be paid back in 30 years, the buyer will receive $50 a year in interest, and then receive $1,000 back at the end of 30 years, if he has not sold the bond in the meantime

 

Changes in the Price of Municipal or Corporate Bond

 

If the bondholder keeps the bond to maturity, the changes in price of the bond are not important.  If the bondholder does wish to sell the bond on the open market before maturity, he will have to take into account the price movements.

 

Consider the example above:  if the bondholder elects to sell the bond after five years, he will have to take the price that the market dictates.  If market interest rates have increased in that time, he will find that the price he can sell the bond at has decreased.  It is an inverse relationship. 

 

Why?  If market interest rates are now 6%, no one is going to pay full price for a bond that only yields 5%.  He will have to sell his bond at an appropriate discount, so that the new buyer will achieve the same effective interest rate as he could when buying a new bond. 

 

The opposite situation is also true.  If interest rates go down, the bondholder will find that his bond is now worth more.  New buyers will be willing to pay more, that is, pay a premium, for a bond with a 5% interest rate, when new bonds are only carrying a 4% rate. 

 

The amount of discount or premium depends on the difference in rates and how long until maturity.  Interest rates are different based on whether the bonds are tax free or taxable.

 

Why Changes in Interest Rates Effect Bond Fund Prices

 

Bonds are also held by mutual funds.  Funds can be comprised of only fixed investments like bonds, or can hold both stock and bond instruments.  Since mutual funds can hold many bonds, some of the bonds are likely maturing regularly and are replaced with new bonds.  Bonds in bond funds are also bought and sold, so the mutual fund undergoes the same changes in price as mentioned above. 

 

Since anyone can buy or sell fund shares at the end of each day, bond funds, like other mutual funds, must be priced out every day.    The price of the bond fund depends on how much interest has been earned but not paid out, and the premium or discount that the bonds would require if the bonds were sold that day, whether were actually sold or not. 

 

Bond and bond fund prices move up and down based on the market.  Buying a bond can be a stable investment, but can be subject to the same market forces as stocks if the bondholder wants to sell the bond before maturity. 

Two Days in the Life of Chipotle

I wanted to take a look at the last few days of trading in Chipotle Stock ($CMG) to try to see if I could gain any lessons from moves that at first seem had to understand.  

There is a long term story but I intend to focus on the short term.  I think most everyone who sees this will be aware of the general issues $CMG has had, namely, a very high valuation, falling stock, food and safety issues.  The stock reached $750 dollars in August and then fell to $400 at the peak of the hubbub over e coli concerns.  

Two days ago the stock had recovered to close at $525 on Monday, 2/22/16. The next morning, the stock received a prominent downgrade from Deutsche Bank analyst Karen Short (love the name) about the same issues that had been dogging the company.  The downgrade was to sell with a price target of $400.

OK, a major Wall Street name (should Deutsche really be from Wall Street?) downgrades, you would expect the stock to drop.  And bang, on Tuesday it did to $511 or so premarket.  Then it opened a bit higher than that, but still down.  Then, all day it started to rise and lo and behold, but the end of the day it was actually went “green” as they say, higher than it started.  It ends the day at $525 again.  The downgrade was, like, completely forgotten.  What the hell?

On Wednesday, the whole market craters when oil goes down, and Chipotle goes back to $512, and when the market reverses like a steamroller $CMG does like, nothing.  It ends at $514.  A roller coaster ride with nobody at the controls.  Or at least that’s the way it seems.

Now, these $10 moves seem pretty big, but they are only 2% moves because of the high share price.  Still, a 2% move day after day is substantial. 

I’m trying to understand.  Why does the downgrade impact share prices for maybe an hour?  There are some who believe that ratings changes are sinister, and that a downgrade is done in order to lower the share price so that the big boys can buy it cheaper (and the opposite for an upgrade so that the smart money can get out at a higher price.)  The conspiracy theorists would add that the large players knew the downgrade was coming so they could sell before it was announced. 

I don’t know whether to believe this, I like to think I am not that cynical.  But otherwise, I am at a loss to know why $CMG moved like this.  It just reinforces my belief that trading intraday moves is just gambling, and there’s little logic to it.   Others may have different ideas.  

Disclosure, I do have a option position on $CMG, looking for it stay near its current price.  

Don’t Wait to Begin Investing

Thomas Bruni @BruniCharting  had a excellent tweet on the difference between investing and trading:

“As a trader/analyst I don't like equities.

As an investor, I'm buying stocks next week, month, year, decade, etc. Know your timeframe/goals”

I started thinking about some of the reasons why people delay investing.  I ran the numbers on what happens if you delay investing because you don’t like the market.

Let’s take a 30 year time frame.   A $4,000 annual investment at a modest 6% return awards you with $339,206 at the end of 30 years. 

If you don’t like this market and spend the money this year money instead of investing it, your payout drops to $316,232.  Postpone investing by five years?  Now your nest egg is down to $236,625.  Spending $20,000 now costs you $100,000 down the road. 

But you don’t the market?  You think maybe a bear market is coming next year?  It doesn’t matter.  If you put your $4,000 in the market and the market drops 20% this year, your fund is worth $333,572 after 30 years.  The 6% annual increase over 29 years more than makes up for one bad year now.

Hey, it’s your money, use it however makes you happy.  But I think you’ll be a lot happier if you have more of it to throw around later when you need it.

Time to go bullish

I don't know about capitulation, overaold conditions or moving averages, but i know when stocks stop going down..  That was today.

I turned bullish this afternoon when the market started to recover.  Shorted some $UVXY and bought a put on $SQQQ which is the Bear ETF for the 3X SPY.

People are way too bearish after the bad start to the year.

I'm Bearish Here

If you've got some money you are going to need in the next few months, or are a short term trader, you probably want to consider pulling it out of the market.

If, on the other hand, you've have money in a 401K with a 20 year horizon, you'd be better served to just wait it out and add more if the market goes down.  20 years is a very long time as far as investments go.  Think back to 1996. Could you have come close to predicting what was going to happen over the next 20 years then?

Big Comeback in Stocks Today - Is it a Good Sign?

The stock market come back big from being down even bigger.  A lot of talk that this is a positive sign for the market, so I wanted to test it.

The $SPY finished just under 2.% off the lows today, so I ran a sample of days where the index finished 1.8% or better above the low for the day.  You could dice it a lot of ways, but this is the one I chose.

It's happened a lot of the last 15 years,  I looked at what happened the following day or days and didn't really see a major trend.  Some days were up, some down and some barely moved.  In looking at the list, I saw it happening a lot in 2008, a very bad year for stocks.  So, I added up the numbers per year.

2015	3
2014	3
2013	2
2012	6
2011	21
2010	13
2009	40
2008	61
2007	7
2006	2
2005	1
2004	2
2003	23
2002	49
2001	40
2000	37
1999	20
1998	27
1997	24
1996	10
1995	2
1994	3

As you can see, the worst years are bear market years, 2008-9 and 2000-2002.  Having a lot of these is a sign of volatility and a bad thing. I can't say what one day will bring, but a lot of them are not good. 

Best of luck trading. 

Why I am short gold today

I sold off all of my money in equities today. Not that I am particularly bearish going into tomorrow’s Fed meeting, just that I don’t have a good feel for what may come out of the meeting.  I expect I will be buying back in after a few days, once things settle down.

The one thing I did keep is a short position in the Miners, Junior Miners and in Silver, via the 3x ETFs.  The reasoning, such as it is, is that the general consensus is that the Fed will be dovish when it announces tomorrow.  I judge this on the fact that gold and silver have exploded to the upside this week.

The strategy is no matter what the Fed announces, good things happen.

·         If they are dovish as expected, then nothing much will happen.  I should get the benefit of those ETFs going down through the daily rebalancing, or through a small selloff.

·         If they are a bit more hawkish, I expect Gold will sell off big time, dragging the miners down with it.

I see it as a win/win, or at least a win/not lose.  It’s the concept of going against a crowded trade. 

I’ll know tomorrow if it works.  If I don’t get shaken out before that.