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Apr 12

Fallacies of Valuing Bonds With Near 0% Interest Rates

Posted by abiao at 14:53 | Others | Comments(0) | Reads(3485)
Bonds are the foundation of many investors' portfolio. The premise behind a bond is simple to understand: an investor wants safety and security rather than partial ownership in a company. The bond gives him that. Additionally, a bond gives an investor the ability to receive consistent income for the life of the contract. However, bonds are subject to a unique type of risk that stocks somewhat immune to.

Interest Rate Risk

Interest rate risk is the risk that a bondholder willingly accepts. It is the risk that the bond's yield will rise or fall above or below the current yield, causing the investor to lose money or to miss out on the opportunity to make more money than he is already making right now.

For example, if you purchased a bond for $5,000 at 8 percent interest, you would receive $400 per year in interest payments. However, if rates rise to 9 percent, your 8 percent bond still only pays $400. You do not get the 9 percent payment. You would have to sell your bond and buy the higher yielding bond. However, when you attempt to do this, you must discount the price of your bond to attract buyers since they will want a good deal on the price of the bond in exchange for the lower yield. The discount is proportionate to the interest you'll make on the new 9 percent bond. This makes it disadvantageous to own a bond at 8 percent when interest rates are rising.

However, when interest rates are falling, you want to be holding a higher yielding bond as long as you're committed to holding that bond to maturity. The problem is that if the bond matures during a low interest rate environment, you're forced to take a lower interest rate on your bond investment. As interest rates rise again, you'll have to face the consequence of rising rates while holding your low interest bond.

Why This Matters To Bondholders

Recently, the Fed chairman, Ben Bernanke, announced his commitment to keep interest rates low until at least 2014. This has caused problems in the bond market because real rates of return plummet when interest rates are held too low.

In general, as interest rates on a bond rise, the price of bonds fall. Conversely, if interest rates on bonds fall, the price of a bond rises. Right now, bond rates are about as low as they can go, and prices are climbing. Trying to value a bond in this environment is extremely difficult since most bondholders buy bonds for the income. As an income investment, bonds are terrible.

The government isn't paying anything for bondholders to hold 10 Treasuries. Its effective yield last month was -.89 percent. The 10 year bond would have to increase to 5 percent before investors would see a real return similar to what was experienced throughout most of the 2000s.

It's impossible to know what the real long-term value of ordinary bonds are simply because we don't have a crystal ball. If interest rates do spike after 2014, the outlook for bonds could be very good. However, financial professionals need to tell their clients something.

Enter TIPS

Investors hate inflation, but they love TIPS. Financial experts love them too. TIPS adjust for inflation, by adjusting the principal amount. When valuing bonds right now, it's safe to assume a negative real yield but the value of those TIPS is that the investor is preserving his value until yields climb back up. If deflation hits, the TIPS investor makes out pretty good, since his investment does not adjust downward to account for deflation.

This removes the challenges of trying to value bond investments in a near-zero interest rate environment. Today, TIPS are preserving the value of an investor's principal amount. Perhaps the best he can hope for right now.

Guest post contributed by freelance finance writer Hayley Russell, on behalf of currency trading analysis specialists Sunbird FX - home to the mobile SunbirdFX metatrader platform. All views and opinions expressed are of the writer and do not necessarily represent Sunbird FX.

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