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The Bull on Bonds

Neil George
Neil George
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We're going to cut through all the bull out there about bonds. Bonds are just what you need.

You've heard it before: Don't own bonds when interest rates are rising or when inflation is whacked out. In reality, the bond market is as diverse as the stock market. And like stocks, not all bonds move at the same time or for the same reasons.

Look at where the core bond market has been during the past year and where it stands now. Governments form the benchmark for how other bonds are valued. The US government market sets the stage for how US and world bonds--denominated in US dollars--trade.

There have been some changes during the last two years. Short-term bills and notes were paying much less than they are now. Yet, yields for intermediate-term bonds (five to seven years) have only edged up modestly, while long- (10 years) and ultra long-term (30 years) bonds have stayed where they were or headed lower.

That destroys the notion that bonds are bad for investors. If you held intermediate- to long-term bonds during the previous two years, you're sitting happy. However, not all bonds were running with the bulls. If you had shorter-term notes, you forfeited some cash.

Forget Uncles Al or Ben

Surprisingly, far too many folks still believe the Federal Reserve Open Market Committee (FOMC) sets the interest rates for the markets. When was the last time you called the Fed to determine the interest on your bond or the cost of your next mortgage?

In reality, we're in a free market where the most the Fed can do is try to influence banks and bond investors. The FOMC only suggests where short-term rates should be, even for fed funds—the excess reserve dollars lent by commercial banks to other banks in need of overnight cash. Member and participating banks set them.

And the discount rate—banks hardly use it. They know better than to go begging from the central bank if they're caught short.

No Bull for Bonds

Bond investors won't deal with bull when it comes to their market. There may be some odd trading to make bonds volatile occasionally. But for the long haul, bond investors are solid.

Bonds ebb and flow for three basic reasons: the current and future direction of inflation, credit or shifting credibility of each bond's issuer and competition for capital.

Even with the prolonged period of higher prices, core inflation remains in the 2-percent range. Global inflation is staying in check for much of the world, despite the solid US economy and near-stagnant European Union.

Issuers' credit conditions--a lot can happen with them for better or worse. We've seen the fallout from the crises at USAir, UAL and other companies that have had their bonds reduced to junk status, sending prices tumbling.

Although some issuers are headed down the dark path, others—from companies to entire countries (e.g., Brazil)—are being upgraded. That's boosting their bond prices.

The last factor is competition for capital. When more stocks are on fire or other investments are soaring (e.g., real estate during the past few years), bonds feel the pinch as investors look elsewhere for deals.

Par, Birdie and Bogey

Bond prices move by small increments daily. But it's those small increments on serious money that can make or break your portfolio.

Bond prices are quoted in terms of percentage of par or whole. A bond priced at 100 is valued at $1,000. Price movements go in decimals, except in a few government markets. So if a bond is priced at 101, it's worth $1,010. Or if the price is 99, it's at $990.

At maturity, bonds end up at par (100). The coupon rate is stated in percent, but yield is to the maturity, based on the internal rate of return of interest and principal payments.

If a bond is priced at 100 with a coupon of 5 percent, the yield to maturity is 5 percent. As the bond price increases, the yield of those 5 percent annual interest coupons—plus the amortization of the bonds' premium price—would fall below 5 percent. Likewise if the price of the bond were less than par, the yield would be higher than the stated coupon percentage.

The longer the maturity, the bigger the price movement for each similar incremental change in yield. For each 1 percent change in yield, a one-year bond would move in price by 1 percent. A five year would move about 3 percent, a 10 year about 7 percent and a 30 year about 14 percent.

This is the impact of duration. Longer duration means more price movement for market yield or interest rate changes. Lower duration means less movement (i.e., stability).

The key is to know what we're expecting in the markets. Then pick the type of bond and the maturity to cash in on the changes--just like you do for stocks.

Neil George will be available to take your questions until Monday, December 12. Please use the form below to submit your questions.

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