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Monday, June 18, 2007
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Rising bond rates give and take
by Stephen Butler
Uh-oh. The headlines are bewailing the fact that interest rates
are rising in the bond markets. This could be trouble.
Of the many factors that influence stock prices, bond interest
rates have the most influence.
Rising rates make it more expensive to borrow, and companies
paying more money in interest have less profit dropping to the
bottom line. Homeowners with adjustable rate mortgages have less
money to spend on "stuff."
This past week, the 10-year bond has seen interest rates rise
suddenly and unexpectedly. This is partly because foreign governments
are suddenly less interested in loaning money to us, so "the
invisible hand of market forces" has had to raise the interest
rate to increase the demand for U.S. government debt.
The 10-year bond is critical because home mortgage interest rates
are tied to this benchmark. Interest rates on new fixed mortgages
and existing adjustable rate mortgages will be rising to reflect
this economic condition.
What does it all mean?
To begin with, foreigners own more than 50 percent of all U.S.
government debt, and at this point, they are tired of seeing their
dollar-denominated loans drop in value against other currencies.
Also, foreign governments issuing debt are paying higher interest
rates. We may have to compete with these higher rates just to
keep our lenders onboard and avoid a major meltdown. I'm old enough
to remember the "spike" in interest rates that occurred
in 1987. It was just before the stock market lost 25 percent of
its value in one day.
More on the future of interest rates, but first let's review
the bond basics.
Bonds are essentially loans to companies, or to the government,
in return for interest payments. The payments continue until the
bond matures, and then the original amount of the loan (the face
value) is returned to you, the lender. Bonds can fluctuate in
value and are valued every day -- just like stocks.
The value of an "old" bond depends on the interest
rate it pays, and how that rate compares with rates currently
offered on new bonds.
If interest rates in the new bond market rise, and the interest
paid on an older bond is lower, then the value of that bond (if
you wanted to sell it) would be lowered until its interest rate
was arithmetically equal to the rate paid by new bonds. On the
other hand, if interest rates plummet in the open market, your
bond paying the older higher rate will suddenly be worth more
than its face value.
Imagine a pulley and a dangling rope. If you tug the interest
rope down, the value rope goes up. and vice versa. Eventually,
however, the loan period ends and the original value of the loan
(bond face value) is paid back. As you approach that pay-back
time, the pulley effect exerts less and less influence because
the remaining time period is too short to matter.
So, here we are with rising rates all of a sudden. Over the past
three years, the rate has risen from 4 percent to 5 percent. If
you bought a 10-year bond back in 2004 that paid about 4 percent,
it is now competing with this week's new bonds that pay 5.25 percent.
Therefore, your old bond will have dropped in value by about
20 percent, but fortunately you only have to hold it for seven
more years to get your full face value back. The recent 20 percent
loss will claw it's way back to respectability as you approach
the pay-back date.
What we have just described is what prompts foreign governments
and other investors to demand higher interest rates before they
will buy more of our U.S. government bonds.
To sell our bonds, we have the compound disadvantage of a falling
dollar, falling bond value because of rising interest rates, competition
from other governments selling bonds that pay higher rates and
that are denominated in stronger currencies.
This could be a problem. Warren Buffet, in his latest annual
letter to stockholders, points out his concern about the extent
to which America has leveraged itself and subjected future generations
to what could be huge costs of spiraling interest on national
debt.
He says, "I believe that at some point in the future U.S.
workers and voters will find this annual 'tribute' so onerous
that there will be a severe political backlash. How that will
play out in markets is impossible to predict -- but to expect
a soft landing seems like wishful thinking."
One man's meat is another man's poison. Rising interest rates
can be a good deal for retirees or people who don't owe much money
and who are looking for income from investments.
Bonds with relatively short periods until they mature (like three
years or so) don't experience much "market rate risk"
such as I described above. If you have some bond mutual funds
that have dropped in capital value, just be patient. Every day
they will be replacing maturing bonds with the new higher interest
bearing bonds and the income stream from interest payments will
gradually rise.
As to what this all means for the future of the economy and the
stock market, all we can do is grip the arms of our chair as hard
as we possibly can.
You can generally disregard anyone who purports to know the answer.
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