wildbill@ucbvax.BERKELEY.EDU (William J. Laubenheimer) (11/20/85)
>Anyone care to offer a brief explanation of why bonds increase in value when >interest rates fall? >Deb Shechter {decvax ! cca | yale | ihnp4 | cbosgd}!ima!deb Nobody else has tried this yet; guess I will. Let's start with the basics. A bond represents a loan which you make to the issuer of the bond, which may be a company such as AT&T, a government such as the state of California or the U.S. government, or an investor or group of investors, as in the "junk bonds" which are frequently offered as part of takeover bids. In return for your loan, the issuer agrees to pay you what is called the *nominal rate of return* on the bond; this is the figure listed with the issuer's name and denotes the simple interest which the issuer agrees to pay you in return for the use of your money. The final part of the description of a bond is the *due date*, the date on which the issuer of the bond agrees to repay your loan. Thus, to take an example which I own: AT&T 8-3/4% Debentures, due May 15, 2000. The issuer of the bond is AT&T, the nominal rate of return is 8-3/4%, and the due date is May 15, 2000. If you had bought $1,000 of this bond when it was issued in 1970, you would receive $83.75 in interest per year until the year 2000, whereupon you would receive your original $1,000 back. Like many other investment vehicles, bonds are traded on the open market. The price of a bond is expressed as a percentage of its *face value*, the amount which is listed on the bond and on which the interest is calculated, and the amount for which the bond will be redeemed at maturity. Not all bonds sell for their face value; some, such as many U.S. Treasury notes, are sold at a discount, others are sold at a premium. The *actual rate of return*, or *yield* of a bond is figured based on its current price, and indicates the return on your investment if you were to buy the bond at that price. It must be calculated in two parts: the amount of interest you will collect, and the capital gain or loss you will sustain from the difference between the current purchase price of the bond and its face value. Thus, for the 9% U.S. bond due in February 1994, which traded on Monday at 96.30, the actual return can be computed as follows: Buy $1,000 face value for $963.00 33 quarterly interest payments of $22.50 = $742.50 Capital appreciation of bond = $ 37.00 ------- Total gain from bond = $779.50 Actual return = $802.00 / (8 1/6 years) = 9.55% The price of a bond normally reflects two things: the creditworthiness of the issuer, and the relationship between the nominal rate of return and current interest rates. The creditworthiness of the issuer affects the price, since part of the price reflects the risk you as the buyer of the bond take in lending the issuer your money. Thus, a U.S. Treasury note, which is virtually default-proof, will trade for a higher price than a bond issued by DEC to pay for their new manufacturing plant, which will trade for a higher price than a bond floated by Carl Icahn to pay for his takeover of TWA. This factor is pretty stable over the life of the bond, though. Now we're ready to consider why bond prices are linked to interest rates. Bonds are competing with other investments, such as stocks and bank deposits, for the money of people wishing to invest it. If you can get 10% by depositing your money in a bank, why should you settle for 9% on a bond, especially considering that bonds are less liquid (you have to find a buyer before you can get your money out). Thus, in order for someone to be willing to buy a bond, the price of that bond must produce an actual rate of return which is some amount above the prevailing interest rate for bank deposits, reflecting the risk assumed by the person wishing to buy the bond that the issuer of the bond will default on the bond, or that the purchaser will be unable to sell the bond before its maturity date if he needs the money. If interest rates go up, the price of a bond will go down, since nobody will be willing to purchase it until the actual rate of return they can obtain has risen proportionately to the rise in interest rates. (Remember, lowering the price of a bond raises the amount of capital appreciation you can get by holding the bond to maturity, thus raising the actual rate of return.) If interest rates go down, the price of a bond will go up, since people will wish to buy bonds which yield more than prevailing interest rates, and raising the price will interest some people currently holding the bond to sell it. And there you have it. Hope this wasn't too windy. Bill Laubenheimer ----------------------------------------UC-Berkeley Computer Science ...Killjoy went that-a-way---> ucbvax!wildbill
wildbill@ucbvax.BERKELEY.EDU (William J. Laubenheimer) (11/20/85)
Small correction to my previous posting:
In the sample actual rate of return calculation, I accidentally forgot to
change a figure from an earlier try. Read "779.50" in place of "802" in
"actual rate of return = $802.00 / (8 1/6 years) = 9.55%"
Bill Laubenheimer
----------------------------------------UC-Berkeley Computer Science
...Killjoy went that-a-way---> ucbvax!wildbill