Bonds Part Two
Painted Ladies – The Wildlife Trusts
Butterflies and Interest Rates
Driving home last week, I thought I was in the “Day of the Locust“ movie. The swarms of locusts turned out to be painted lady butterflies. They are small butterflies. They fly amazingly fast. There were millions of them (not an exaggeration) migrating north from Mexico. I hoped they would manage to fly above my windshield.
Enter “California’s super bloom attracts swarms of migrating butterflies” into your browser to read the story.
It made me think about the following:
“A butterfly flapping it’s wings in Brazil can cause a hurricane in Texas”
With millions of butterflies flying up the west coast, I wondered where the hurricane was going to land.
The Butterfly Effect, not the swarming kind, is a term used in mathematics, economics, social sciences, and other disciplines to describe chaos theory.
If you think the markets seem chaotic and unpredictable, you are experiencing The Butterfly Effect.
In chaos theory “a slight change in something that appears insignificant and unrelated may greatly affect its outcome”. [1]
A small change, or no change in interest rates, can lead to unforeseen or unexpected consequences.
This is what happened last week when the Fed decided to maintain interest rates through 2019.
The flapping of wings caused an immediate reaction in the stock and bond markets. The longer-term effects we may not see for months.
If investors believe interest rates are going up, they may hold off investing in bonds. Bonds lose value when interest rates go up.
Corporations may decide that borrowing money ( issuing bonds ) in a rising interest rate environment will cost to much, so they delay raising capital for projects or research.
Bonds issued for infrastructure projects like highways or schools, will be delayed meaning there is no money available to fix potholes or hire teachers.
In this analogy the small change in interest rates, something that to us appears insignificant, may cause a school or a highway to close for lack of funding. School closings lead to poorer education for the students. Highways closing make it more difficult to drive to work.
In each case there will be some unpredictable consequence caused by something that appears unrelated.
What do you need to know about interest rates when you are making an investment decision?
Investing is all about the money you are going to make and how much risk you are willing to take.
Interest rates tell you if your expectations for returns are realistic. Interest rates also tell you something about the quality of a bond.
When you buy a bond, there are different factors to consider but the first factor is the interest rate a bond is paying.
Treasury bonds are considered the least risky of all the categories of bonds. They have an implied Aaa rating by Moody’s and an implied AAA rating by Standard and Poor’s, the highest ratings any bond can have.
When the credit quality of a bond is high investors are willing to buy a bond with a low interest rate as a type of insurance. Investors are willing to receive a low interest rate because the risk of a default is also very low.
Because the Treasury has the highest credit score possible, they are going to pay a low rate of interest on the money they borrow.
You the investor lend money to the Treasury when you buy a Treasury bond. In return the Treasury pays you a fixed interest rate.
You can choose from a very wide variety of bonds. Bonds all have different interest rates.
Corporations issue bonds, states and cities issue bonds, governments outside the US issue bonds. Every bond has a specific maturity date and a fixed rate of interest.
When the interest rate on a bond is high it typically means that the credit quality is low.
There is a reason junk bonds are called junk bonds and pay a high rate of interest. The high rate is an indication that it is very possible the bonds could default.
When you know that a 10-year treasury bond pays 2.5% and you see a 10-year corporate bond paying 8% – whoa! Something is amiss. Check the credit rating.
Using the yield on a 10-year Treasury is like a point on a map. It is a landmark that you will use when comparing other bonds
The link below takes you directly to the daily yields on treasury securities.
Your point of reference for interest rates is 2.44%*
Two days after the Fed announced it would not be raising rates this year, interest rates dropped by 17 basis points and bond prices went up.
You don’t have to be interested in interest rates or look at them every day. The purpose of this article is for you to know what interest rates are and to have a point of reference when comparing bonds. On the map, it is the place you start.
[1] The quote is by Kieran D. Kelly in his article on Chaos Theory and Economics.
http://www.kierandkelly.com/chaos-economics/
*as of March 22, 2019
This website is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation for any security, nor does it constitute an offer to provide investment advisory or other services by The Modest Economist LLC.
