Understand investment basics - bonds yield, bonds investment and bonds price. Know China influence on bond demandAlthough bonds investment is characterized by its face value, coupon rate, maturity and issuer, one very important investment basics that savvy investors know is called bonds yield. Yield is the rate of return you get on bonds. When price goes up, yield goes down, and vice versa. When interest rates rise, the price of bonds in the market falls; and vice versa.
Bonds yield or interest is stable but bonds prices can fluctuate a lot... bonds investment can be a risky instrumentWe need to elaborate a bit about the bonds prices. The bonds prices are merely affected by demand and supply. Please do not think that bonds prices will change after FOMC meeting. Federal Reserve can only change fed fund interest rate (short yield). Theoretically bond price is the net present value of the bond interest rate (yield). In reality, the bond sales are a bidding operation. The lower interest rate that completes the bond sales lot.Bonds are generally viewed as safer investments than equities, but this perception is only partially correct. Treasury bonds do suffer from less day-to-day volatility than stocks, and bonds interest payments are generally higher than dividend payments. Treasury bonds are liquid, though not nearly as easy as it is to sell stocks. The bonds prices can be very volatile on short term trading. Why? Bonds, a general understanding, will decrease in value when prevailing interest rate rises. When the market's interest rates rise, then the market price for bonds will fall, reflecting investors' improved ability to get a good interest rate for their money elsewhere. This is predominantly an opportunity costs concept of holding bonds. It is because you can always purchase newly issued bonds that feature the newly higher interest rate. This drop in the bonds' market price does not affect the interest payments to the bondholders at all. Therefore long-term investors need not worry about price swings in their bonds if they hold to maturities. However, price changes in a bond immediately impacts your current holding particularly if there is any chance you need to sell your bonds and "cash out" for some reasons. On the other hand, bonds' market prices would increase if the prevailing interest rate were to drop, as it did in 2008. You can cash in a big profit on selling your on hand holding bonds not to wait for their maturities. You can think of this in the following way: If you own an asset worth $100 that gives you a 6.0% interest annually for 10 years, will you ask for a HIGHER price if someone wants to exchange you with an asset worth $100 but gives you only 4.5% interest annually? Definitely yes! In other words, your current bond holding bearing 6% interest worth more than the new issue bearing only 4.5% interest. This means you have a good investment having a capital appreciation because you correctly predict the interest rate to drop when you buy the 6% interest debt in the first place!
Real demand & supply determine the bonds yieldThe next question is: what are the factors that drives down the yield from, say from 6.0% to 4.5% and hence raise the bonds price? Remember that bond sales are bidding operations? You may think about this way: There are many investors in bonds. These investors are preparing for their own bids. That is, investors are figuring out the lowest yield or return that they are prepared to accept bonds in exchange for his US dollar cash on hand...Look at bonds price from an opportunity costs concept In making this decision to come up with 4.5%, they will compare investment opportunities for risks and returns. For instance,
On the supply side, we all know that US government is the sole supplier of new issue of US treasury. Yet all the existing bonds holders can also supply by selling in the open market. On the demand side, there are different types of investors:
One point to note is that China can drag up the US treasury yield a lot if China disposes of its holdings on hand. It seems that this is not happening as this is lose-lose scenario. The huge amount of bonds on hand with China would suffer at a revaluation loss (or actual loss). In fact, China US treasury holdings are having hugh profits since these treasury notes were purchased at much higher yield than the current (Sept 2011) benchmark 10-year note of less than 2%... One would expect US Treasury bonds demand to reduce, bonds price to drop, long yield to rise and mortgage rate to raise deterring consumer spending; and subsequently US government obliged to pay a higher interest to attract potential investors. However, the US Fed is buying its own Treasury bonds / notes to artificially lower the bonds yield...
More on bonds investment...
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