The Economy Guy

Issue: 11/01/07 Thursday – A Bond Lesson….

We live in turbulent times, and it was the stock market’s turn to become turbulent.  The Dow fell 2.6% – a very large 362 point drop off the cliff. Why??  Well, people are getting worried about what the Fed said yesterday (you can’t discount the potential of inflation in the future), and other people are worried that the liquidity problem hasn’t finished making a bunch of companies perform very poorly in the future (think financial companies, banks, house builders, transportation companies, home building supply companies, etc.)

Along with this dramatic drop in the stock market, the bond market picked up.  It usually does in this circumstance, and today was no exception.  The 10 Year Bond closed at 4.36%, down 0.11% – a truly dramatic change.

I would like to take this opportunity to talk a little about bonds.  When would bonds be a great investment?  Well, the easy answer is when interest rates go down.  The harder question to answer is “what has to happen to today’s economy to make interest rates go down??”  The easy answer to this question is “If the US goes into a recession!!!”

So, the next obvious question is “How much money could I make in bonds if the US goes into a recession?”  That is a tough question.  Here is how the bond market works.  Bond prices are proportional to the inverse of their interest rate.  Too mathematical a statement?  Okay.  Before I give a better understanding, I’d like to make it real clear that my previous definition is wrong.  However, for anyone wanting to make a back of the envelope calculation, the “inverse” definition is correct IF the term of the bond is 15 years or greater.  It’s even good enough for a 10 year bond.

Today, the 10 year bond sits at 4.36%.  What if it falls to 2.18%??  That doesn’t sound like you could make much money, does it?  WRONG.  You would almost double your money if you purchased the bond WITHOUT using any leverage (like margin, or other more exotic methods).  You see the value of the bond would double if the market interest rate moved from 15% to 7.5%, or 10% to 5%, or 4% to 2%, or 2% to 1%.  Are you kind of getting the pattern here?  You see, it is easy to make a fortune in bonds – especially when they are at a low interest rate – like right now.  That’s why I get real excited when I see a ONE DAY change in the 10 year bond interest rate of 0.11%.  That is HUGE.  Oh, by the way, I didn’t mention that bonds also pay a fixed interest payment.  So, you actually make more money.

Don’t jump out of your seat and buy bonds !!!!!  Why???  You probably don’t know enough to take the risk.  You see, in order to jump out of your seat, you MUST be absolutely confident that interest rates are going to fall, and fall a long ways; and that it is driven by a big recession in the US.  I don’t think anyone could be that confident today.  But, you might gain that type of confidence tomorrow, and that’s why I’m writing this article right now.

Now I’ll really whet the appetite of those crazies who love Las Vegas, and can’t live without gambling.  I do NOT recommend this strategy, but I want to drive home the point that it’s possible to make a fortune in bonds.  It is possible to purchase bonds on margin.  And, as the big rule makers in the sky think that bond investments are much more secure than stock investments, they have said you can buy bonds with only 10% of the purchase price.  In other words, you can borrow 90% of the money on margin.  What does this mean if the underlying, market interest rate drops in half????  Are you ready??  It mean the total value of the investment would increase 20 fold.  That’s a 1900% increase in the value of your investment.

Am I crazy??  No.  I’ve done even crazier bond investments.  When I owned some bonds that had already increased in value (because the market interest rate had dropped), I purchased more bonds – and didn’t put any more money into the transaction.  I bought them on 100% margin, as they were covered by the existing bonds in my portfolio.  In fact, the market was so crazy that the interest that the bond paid me more than paid for the margin interest.  So, I purchased bonds with no money, and they paid me a net interest payment, and they increased in value as interest rates continued to fall.  Why was I so confident that I could make that type of investment?  IT WAS RISKY, and I knew it.  I was absolutely confident that interest rates would continue to fall – and they did.

Now, I would like to STRONGLY tell all the readers that if they did something like that today, they would probably end up bankrupt – so don’t do it.  No one can know FOR SURE that interest rates will fall.

Here are Thursday’s closing details:
DJ30 – 13,568 (Down 362 points)
10 year US Treasury Bond – 4.36%  (Down 0.11%)
Euro 1.4421
Gold closed at $794 per ounce. (Down 2)
Oil Closed at $93.49 (Down 1.04)
Gasoline is $2.35 (Up 0.01)