Best of the Week
Most Popular
1. Market Decline Will Lead To Pension Collapse, USD Devaluation, And NWO - Raymond_Matison
2.Uber’s Nightmare Has Just Started - Stephen_McBride
3.Stock Market Crash Black Swan Event Set Up Sept 12th? - Brad_Gudgeon
4.GDow Stock Market Trend Forecast Update - Nadeem_Walayat
5.Gold Significant Correction Has Started - Clive_Maund
6.British Pound GBP vs Brexit Chaos Timeline - Nadeem_Walayat
7.Cameco Crash, Uranium Sector Won’t Catch a break - Richard_Mills
8.Recession 2020 Forecast : The New Risks & New Profits Of A Grand Experiment - Dan_Amerman
9.Gold When Global Insanity Prevails - Michael Ballanger
10.UK General Election Forecast 2019 - Betting Market Odds - Nadeem_Walayat
Last 7 days
You Should Be Buying Gold Stocks Now - 6th Dec 19
The End of Apple Has Begun - 6th Dec 19
How Much Crude Oil Do You Unknowingly Eat? - 6th Dec 19
Labour vs Tory Manifesto Voter Bribes Impact on UK General Election Forecast - 6th Dec 19
Gold Price Forecast – Has the Recovery Finished? - 6th Dec 19
Precious Metals Ratio Charts - 6th Dec 19
Climate Emergency vs Labour Tree Felling Councils Reality - Sheffield General Election 2019 - 6th Dec 19
What Fake UK Unemployment Statistics Predict for General Election Result 2019 - 6th Dec 19
What UK CPI, RPI and REAL INFLATION Predict for General Election Result 2019 - 5th Dec 19
Supply Crunch Coming as Silver Miners Scale Back - 5th Dec 19
Gold Will Not Surpass Its 1980 Peak - 5th Dec 19
UK House Prices Most Accurate Predictor of UK General Elections - 2019 - 5th Dec 19
7 Year Cycles Can Be Powerful And Gold Just Started One - 5th Dec 19
Lib Dems Winning Election Leaflets War Against Labour - Sheffield Hallam 2019 - 5th Dec 19
Do you like to venture out? Test yourself and see what we propose for you - 5th Dec 19
Great Ways To Make Money Over Time - 5th Dec 19
Calculating Your Personal Cost If Stock, Bond and House Prices Return To Average - 4th Dec 19
Will Labour Government Plant More Tree's than Council's Like Sheffield Fell? - 4th Dec 19
What the UK Economy GDP Growth Rate Predicts for General Election 2019 - 4th Dec 19
Gold, Silver and Stock Market Big Picture: Seat Belts Tightened - 4th Dec 19
Online Presence: What You Need to Know About What Others Know About You - 4th Dec 19
New Company Tip: How To Turn Prospects into Customers with CRM Tech - 4th Dec 19
About To Relive The 2007 US Housing Market Real Estate Crash Again? - 3rd Dec 19
How Far Will Gold Reach Before the Upcoming Reversal? - 3rd Dec 19
Is The Current Stock Market Rally A True Valuation Rally or Euphoria? - 3rd Dec 19
Why Shale Oil Not Viable at $45WTI Anymore, OPEC Can Dictate Price Again - 3rd Dec 19
Lib Dem Election Dodgy Leaflets - Sheffield Hallam Battle General Election 2019 - 3rd Dec 19
Land Rover Discovery Sport Brake Pads Uneven Wear Dash Warning Message at 2mm Mark - 3rd Dec 19
The Rise and Evolution of Bitcoin - 3rd Dec 19
Virtual games and sport, which has one related to the other - 3rd Dec 19
The Narrative About Gold is Changing Again - 2nd Dec 19
Stock Market Liquidity & Volume Diminish – What Next? - 2nd Dec 19
A Complete Guide To Finding The Best CFD Broker - 2nd Dec 19
See You On The Dark Side Of The Moon - 2nd Dec 19
Will Lib Dems Win Sheffield Hallam From Labour? General Election 2019 - 2nd Dec 19
Stock Market Where Are We?  - 1st Dec 19
Will Labour's Insane Manifesto Spending Plans Bankrupt Britain? - 1st Dec 19
Labour vs Tory Manifesto Debt Fuelled Voter Bribes Impact on UK General Election - 30th Nov 19
Growing Inequality Unrest Threatens Mining Industry - 30th Nov 19
Conspiracy Theories Are Killing This Nation - 30th Nov 19
How to Clip a Budgies / Parakeets Wings, Cut / Trim Bird's Flight Feathers - 30th Nov 19
Hidden Failure of SIFI Banks - 29th Nov 19
Use the “Ferrari Pattern” to Predictably Make 431% with IPOs - 29th Nov 19
Tax-Loss Selling Drives Down Gold and Silver Junior Stock Prices - 29th Nov 19
We Are on the Brink of the Second Great Depression - 29th Nov 19
How to Spot REAL Amazon Black Friday Bargains and Avoid FAKE Sales - 29th Nov 19

Market Oracle FREE Newsletter

UK House prices predicting general election result

If You Don’t Understand Bonds, You Don’t Understand Investing

Interest-Rates / US Bonds Aug 25, 2019 - 09:17 AM GMT

By: Jared_Dillian

Interest-Rates

The first thing I read about investing wasn’t actually a book. It was a pamphlet that I got somewhere, 23 years ago.

The pamphlet said you should invest in bonds as well as stocks. It said bonds went up when interest rates went down, and vice versa. It didn’t go into any more detail.

Well, I did what the pamphlet said, even though I had no idea what the hell I was doing, and I wouldn’t figure out for a few more years why it was a good idea.

I suspect a lot of people don’t take that advice on diversification simply because they don’t know what the hell they are doing.


But bonds are more important than most of you think they are…

You Have to Understand Bonds

I taught finance at Coastal Carolina University for five years. Four years in the MBA program.

In the MBA program, I used to teach a course called Financial Institutions and Markets, which I loved.

After the semester, one of the students came up to me and said he expected to learn all about how to trade stocks in the class.

He thought the whole class would be about the stock market, when in fact, about 85% of the class ended up being about the bond market.

I told him, “Yeah, the stock market is quite a bit smaller, and frankly, it isn’t that important. People focus on it because stocks are easy to understand.”

“But if you want to understand how the world works, you need to understand bonds.”

He was a non-traditional student, so I’m not sure what he did with his bond knowledge. But at least there is one more financially literate person out there.

Here I’ll take a quick look at a few different types of bonds.

What Bonds Should I Buy?

Treasury bonds are relatively straightforward.

The government borrows money from the public in the form of bills, notes, and bonds. For years, these bonds were considered to be “risk-free,” though you could have a much longer discussion on that now.

The interest rates on Treasury bonds are pretty much the benchmark for every other interest rate in the world, including your mortgage. They also give you a pretty good indication as to which way the economy is going—if you know how to make sense of the numbers.

Buying a Treasury bond is a pure play on the direction of interest rates. If you think interest rates are going down, you would buy Treasuries. Which is a bit ghoulish, because if interest rates go down, it is supposed to mean bad things are happening.

I think you have just figured out one reason you need bonds in your portfolio.

Corporate bonds are debt issued by corporations. Also straightforward.

But corporates are considered to be riskier than the government, so their interest rates should be higher (because you should be rewarded for taking on more risk), and they generally are.

The difference between Treasury and corporate interest rates is called a spread, and trading corporate bonds is often called spread trading.

Corporate bonds are rated by rating agencies, and the higher-rated ones are called investment grade, and the lower-rated ones are called high yield.

High-yield bonds have higher yields, as advertised, but are riskier and more likely to default. Investment grade bonds don’t default very often, but people have become concerned recently about the perceived riskiness of lower-quality investment grade corporate bonds.

From the survey: 26% of you who are invested in bonds are holding investment grade corporate bonds, versus just 4% holding high-yield bonds. If you’re among the 26%, now is a good time to check how much of your holdings are lower-quality investment grade (BBB).

Mortgage-backed securities are pools of mortgages on residential real estate.

Your mortgage has been securitized into a pool which can be bought by investors. Your principal and interest payments are passed through the bond to the investor (MBS are frequently called pass-thrus).

I would need more time to explain exactly how MBS’ behave, but just know that when interest rates go down, the value of MBS don’t go up very much… yet when interest rates go up, the value of MBS go down a lot.

Kind of the worst of both worlds. Why buy these bonds? They yield a bit more because of the prepayment option, which has to do with the refinanceability of your mortgage.

Sovereign/International bonds are bonds issued by foreign countries or foreign corporations. Some of them are denominated in US dollars, and some of them aren’t. The ones that are denominated in local currency obviously give you exposure to that currency. The currency exposure is generally the overriding concern with these bonds.

Sovereign bonds are neat because to analyze them, you generally need to analyze political risk, and you have to be up on politics in foreign countries. That’s fun, but not necessarily a great idea.

Sovereign bonds are generally treated as corporate bonds—they trade at a spread to US Treasuries.

Municipal bonds are bonds issued by state and local governments. Municipal bonds have had a historic rally recently.

The interest on municipal bonds is exempt from federal taxation, and sometimes state and local taxes, which makes them appealing to investors in high tax brackets. If you are in a low tax bracket, munis are generally a waste of time because the yields are so low.

Some municipalities are in terrible financial shape, which sometimes keeps people from investing in their bonds, but they rarely default, because, well, you can always raise taxes.

There are also tens of thousands of issuers and financial data is typically not available, so the market is famously murky. Also, the Puerto Rico municipal bankruptcy is working its way through the court system and might be setting some not-nice precedents for muni bond investors.

Just Scratching the Surface

The thing that sucks about investing is that you have a full-time job where you work eight hours a day, but you have to somehow also make smart investing decisions.

The reality is that your financial education is your own responsibility, so you have to put in additional work to learn about the financial markets. And the knowledge barrier to entry with bonds is a bit higher than with stocks. There is quite a lot to learn.

I guess you could just cede control to some mook and pay the mook 1.25%. Not to demean the advisory industry, but financial advisors have a powerful incentive to get you to take as much risk as possible—clients are angriest when they underperform the market.

If the mook option doesn’t sound like a good idea to you, you have to do the work.

Get Contrarian Investment Ideas from a Wall Street Veteran

Jared Dillian writes The 10th Mana free weekly newsletter for contrarian investorsEvery Thursday, he delivers a torpedo of incisive commentary that crushes consensus thinking and exposes the true workings of “Mr. Market.”  Subscribe now!

By Jared Dillian

© 2019 Copyright Jared Dillian - All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules