A thought while the topic du jour is the Fed's reduction in the Fed Funds interest rate and expectations for future rate cuts.
Two popular misconceptions: The first being that the Fed controls the interest rate for mortgages, car loans, credit cards, etc.
False.
The Fed controls only the Fed Funds rate it charges banks for overnight borrowings. The market controls everything else.
IF (two huge letters) the Fed and the financial markets have a passably similar view of the current and future economic strength or weakness, the Fed Funds rate can indirectly influence longer-term rates. But if their views diverge, the Fed Funds rate will have little to no influence on what individual or corporate borrowers pay for money.
The second misconception is that you can't lose money on US Treasury bonds, and the chances of losing money on quality corporate bonds is really really low.
Also false, even if you assume zero probability of default.
IF (there's those two huge letters again) you buy a Treasury or high-quality corporate bond and IF you hold it to maturity, you'll get both your agreed-upon interest payments and all your principal back at maturity.
The sticking point comes if you buy the bond, then later on for whatever reason, you want to sell it prior to maturity. If you do that, you're exposed to the risk of loss.
Here's the greatly simplified story: Say you buy a 20 year bond paying 5%. Three years later (17 years prior to maturity), you want to sell. But in that three year period, the market rate has risen to 7%. The market value of that bond has taken about a $2,000 hit -- and that loss is totally unrelated to the fact that you'll eventually get all your contracted money.
Point of all this being, practice good asset / liability management in your investments. Resist the temptation to chase yield going buying longer maturities. Because, dang it, the short-term stuff pays so little.
If you do that, you're exposing yourself to the risk of loss of market value.
For those who care to read, here's the geekier version of why that happens:
A bond is a stream of cash payments. Say you buy a $10,000 bond paying 5% per year, maturing in 20 years. To make the math less complicated than it already is, we'll assume single annual payments of 5% of $10,000 -- or $500. Then at maturity, 20 years down the road, you get your principal back in a one-time payment.
Suppose further that the market rate for a 20-year maturity is 5% the day you buy the bond. The financial markets will discount the stream of 20 annual payments of $500, plus the one-time payment of $10,000 in 20 years to present value at the market interest rate. On Day 1, that's 5%. The present value of the stream will be $10,000 -- or par.
But suppose that three years later, the rate for 20-year money rises to 7%. Now you're discounting the fixed payment stream to present value at 7%. But the payments you receive are fixed at the old 5% rate.
The present value of 17 annual payments of $500, discounted at the new market rate of 7% is $4,881. The present value of the one-time return of $10,000 principal 17 years into the future is $3,166. Your bond is worth the sum of the two. Problem there is $4,881 + $3,166 is only $8,046. Your bond is worth not quite $2,000 less than what you paid for it.
Worse, due to the effects of exponential math, the longer you go out on the maturity, the bigger the loss. If you bought a 30 year bond paying 5%, and three years later want to sell it in a 7% market, your bond will be worth about $7,600 -- a $2,400 loss of market value.
Two popular misconceptions: The first being that the Fed controls the interest rate for mortgages, car loans, credit cards, etc.
False.
The Fed controls only the Fed Funds rate it charges banks for overnight borrowings. The market controls everything else.
IF (two huge letters) the Fed and the financial markets have a passably similar view of the current and future economic strength or weakness, the Fed Funds rate can indirectly influence longer-term rates. But if their views diverge, the Fed Funds rate will have little to no influence on what individual or corporate borrowers pay for money.
The second misconception is that you can't lose money on US Treasury bonds, and the chances of losing money on quality corporate bonds is really really low.
Also false, even if you assume zero probability of default.
IF (there's those two huge letters again) you buy a Treasury or high-quality corporate bond and IF you hold it to maturity, you'll get both your agreed-upon interest payments and all your principal back at maturity.
The sticking point comes if you buy the bond, then later on for whatever reason, you want to sell it prior to maturity. If you do that, you're exposed to the risk of loss.
Here's the greatly simplified story: Say you buy a 20 year bond paying 5%. Three years later (17 years prior to maturity), you want to sell. But in that three year period, the market rate has risen to 7%. The market value of that bond has taken about a $2,000 hit -- and that loss is totally unrelated to the fact that you'll eventually get all your contracted money.
Point of all this being, practice good asset / liability management in your investments. Resist the temptation to chase yield going buying longer maturities. Because, dang it, the short-term stuff pays so little.
If you do that, you're exposing yourself to the risk of loss of market value.
For those who care to read, here's the geekier version of why that happens:
A bond is a stream of cash payments. Say you buy a $10,000 bond paying 5% per year, maturing in 20 years. To make the math less complicated than it already is, we'll assume single annual payments of 5% of $10,000 -- or $500. Then at maturity, 20 years down the road, you get your principal back in a one-time payment.
Suppose further that the market rate for a 20-year maturity is 5% the day you buy the bond. The financial markets will discount the stream of 20 annual payments of $500, plus the one-time payment of $10,000 in 20 years to present value at the market interest rate. On Day 1, that's 5%. The present value of the stream will be $10,000 -- or par.
But suppose that three years later, the rate for 20-year money rises to 7%. Now you're discounting the fixed payment stream to present value at 7%. But the payments you receive are fixed at the old 5% rate.
The present value of 17 annual payments of $500, discounted at the new market rate of 7% is $4,881. The present value of the one-time return of $10,000 principal 17 years into the future is $3,166. Your bond is worth the sum of the two. Problem there is $4,881 + $3,166 is only $8,046. Your bond is worth not quite $2,000 less than what you paid for it.
Worse, due to the effects of exponential math, the longer you go out on the maturity, the bigger the loss. If you bought a 30 year bond paying 5%, and three years later want to sell it in a 7% market, your bond will be worth about $7,600 -- a $2,400 loss of market value.
