Bonds, unfortunately, are nowhere near as exciting as the actual 007. Or at least, they’re not supposed to be. Maybe a Roger Moore 007 though, those were all pretty boring. A bond is an IOU - a promise to give your money back in the future with periodic fixed interest payments in the meantime. They used to be issued as actual certificates, with little coupons that you would clip off every six months and turn in to receive your interest payment, but alas, those days are gone.
So, if you get your money back (let’s call that amount “100”) at some point in the future and in the meantime are collecting interest payments, how much is that bond worth? 100? 102? 96?
It’s the same basic question as the time value of money from last month. Bond valuation is based on two things: 1) the interest rate of the bond relative to the current interest rate in the market, and 2) the quality of the company issuing the bond. So going back to last month’s three-step valuation methodology:
Step 1 - Objectively: Earlier this year, 10-year US Treasury bonds had an interest rate of 2.5%. That rate is fixed for the life of the bond (hence “fixed income”). Right now, the interest rate is about 2.1%. That makes the bond issued at the start of the year more valuable, because it’s paying 2.5% instead of 2.1%, so it will be priced higher than 100 (more like 103 or 104). If interest rates had instead gone up, then the value of the 2.5% bond would have gone down.
Step 2 - Subjectively: In last month’s example, the future payout was guaranteed. In the bond world, repayment is not guaranteed because the company might default (go bankrupt), so you much adjust valuations based on potential default risk. If you have a 10-year US Government bond yielding 2.25% that is priced at 100, you would probably have a 10-year General Motors bond yielding 2.25% that is priced around 85, since GM has a greater risk of bankruptcy than the US Government. (In actuality, it’s more likely that you would see the GM bond priced closer to 100 but yielding more like 5% in that case, because nobody in their right mind would buy a GM bond that only yielded 2.25%...)
Step 3 - Clark Gable: ...or would they? Because interest rates have been kept at or near zero for the last decade, the bond market is now much more Pierce Brosnan 007 than Roger Moore. (filled with action and absurdity).
For example, Argentina issued $2.75 billion of 100-year bonds at 7.125%. Please note that Argentina has defaulted on its debt roughly once every 25 years for the last two centuries. Also, you will not be alive when that debt matures, so you effectively never get your money back, default or no default. Further, there is currently $10 trillion (with a “t”) in debt globally that has a negative interest rate. That’s right, you don’t get any interest payments; instead, you actually have to pay interest yourself to own the bond. Absurdity.
Some piles are good. Piles of sand, for example, create dunes that help protect the island from the next storm. Piles of debt do the opposite and make the economy more vulnerable to the next storm. And apart from that pile of negative yielding debt, we’re also sitting on the biggest pile of corporate debt history. If all that sounds a bit frothy, well, what can we say. We like our bubbles shaken, not stirred.
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