How Bonds Work

"True Knowledge exists in knowing that you know nothing" – Socrates

Welcome to The Golden Sense! I was at a dinner party just a few weeks ago in Santa Barbara and came into conversation with a gentleman my age who was a PhD student in Psychology. I was interested in talking to him because I have acquired a BS in Psychology. I spoke to him about his program and research studies. He was studying the effects of appetite and exercise on motivation. Then the conversation moved in the opposite direction and we began discussing the banking world. I told him that I managed a banks bond portfolio. He confessed to me that he didn't even know what a bond was. Well, that statement motivated me and I began by saying; the bond market is one of the biggest investment markets in the world and historically has been a safe place to invest money. I did note that this perception is poised to change rapidly.

So what is a bond? A bond is a debt security. It represents a loan to the government, a state, a country a municipality, or a corporation. A bond is simply a unit of debt that a borrower sells to an investor. A bond is a formal contract to repay borrowed money with interest at fixed intervals (semiannual, annual, and sometimes monthly). A bond is called a fixed income security.

So let’s get away from the technical terms. They just might confuse or bore you to death. Bonds are important to understand because at some point in your life you will probably want to make money in the bond market.

 Here is a simple example:

Let’s say the State of California needs money (as they often claim). They can go out and issue "bonds" to raise money. Let’s say they need $1,000 dollars. The state wants to use the $1,000 for 10 years all the while paying the person who lent them the money $20 every year before repaying the lump $1000 back at the end of 10 year period.

Under this typical scenario, the $1,000 is the issue amount. The 10 years is called the "term". The $20 represents a 2% interest rate on the $1,000 bond. This 2% is called the "coupon".

Bonds are almost always issued in on thousand dollar denominations. Bonds are quoted in percentages. Bonds are quoted at 100, also called par. A bond quoted at 100 would sell for exactly one thousand dollars. The term par equals $1,000.

A bond provides a certain interest rate or "yield". That is the return you will receive on your original investment regardless of whether the bond rises or falls in price on the open market.

Interest rates in the open market change daily. These daily changes affect the daily market price of bonds. Bonds move inversely with prevailing interest rates. As interest rates move up, the price of bonds moves down. As interest rates go down, the price of bonds move up.

Here is an example. Let’s say that you own that $1,000 California bond that is paying 2% interest or $20 a year. Suppose that interest rates rise on the open market. The price of your bond paying 2% will decline. That means you would be selling your bond for less than $1000. If you keep your bond, then regardless of this price change you will still be receiving your 2% interest or $20 a year on your bond till the maturity date. If interest rates decline on the open market, then the price of your bond will rise. This is important because then you have to decide whether to sell your bond for a profit or continue collecting the 2% interest or $20 a year on the bond. Remember, if you choose to sell your bond you will then have to pay capital gains taxes.

When analyzing a bond, you should look at three aspects.

First, the bonds yield to maturity.

Second, look for the yield to call. Some bonds allow the issuer to call the bond at a certain price at a certain time. The yield to call shows you what you will earn up to the possible call date. Not all bonds are callable. If it is then you should take into consideration the date that it might be called at. If a bond is not callable it is termed a "bullet".

Third, check the premium on the price based on the day or the hour you buy the bond. Try to avoid paying high premiums.

Bonds can be good investments because they offer a stable income. You will know exactly how much you will receive with a bond investment if you hold it to maturity.

It is very important to understand who is issuing the bond. When buying a bond, make sure you feel comfortable with whom the issuer is. S&P and Moody's rate almost all bonds. I usually suggest sticking to the A-AA+ rated bonds.

In 2012, many bonds are selling at high premiums due to the low rates on the open market. In simple terms, bonds are overpriced. Due to the extreme low rates many analysts are calling a top in bond market by claiming that low rates are coming to an end. It would mean the long drought, which this low interest rate era has been, is finally coming to an end. That would make a lot of investors happy because they’d finally be able to obtain some income. Keep in mind; bonds have been in a 30 year bull market.

This view is debatable because other analysts are saying low rates are here to stay for another five years. The Federal Reserve has made its presence felt in the bond market by artificially keeping interest rates low by going on a buying spree in bond market. The Federal Reserve has stated publicly that they intend to keep rates low throughout 2015.

At this point in time I would say that bonds are a very dangerous investment for an individual to make. My advice is to leave the bond market to the banks and institutions and take your personal money elsewhere.

Doug Casey makes a good point about the current bond market by saying, "bonds are a triple threat to your welfare. You've got the interest-rate threat. Interest rates could only go up at this point since they're at zero. You've got the credit-risk threat. Will they be able to pay back the dollars, or Euros, or yen, or whatever that they are in? And you've got the currency threat. Will the yen or dollars or Euros or whatever be worth anything, even if they pay them back to you? I don't see why, but every body's buying bonds. Institutions are buying them; the average guy is buying them – trying to reach for 2% in yield when real inflation is probably running 5-6% per year."

If you want to profit in a rising rate environment you can always buy ticker "TBT". Do not take that as investment advice. I am not recommending anything; the bond market is in uncharted territory and rates could do anything at this point.

Besides the current dangers in the bond market, it is a market that is important to understand because it could be of great use to you one day. There are many investment tools in the world and each one of them can be extremely valuable as long as you use it properly.

As Ani DiFranco said, "Any tool is a weapon if you hold it right".

Sincerely,

T. Norman

Apple recently released its new iPhone 5. Apple has been making killer profits and this iPhone release has sold more than the iPhone 4 release. However, now their is something a little different about the phone. Once upon a time, Apple and Google were partners. Well, sort of. Google Maps was far and away the best service of its kind in the world. Apple recognized that and has been happy to feature it on the iPhone since 2007... or, if not exactly happy, willing to grant Google a grudging acceptance. Apple users expected to find Google Maps on their phones. Until... well, until they didn't anymore. The new iPhone now has a different mapping system. Google Maps is gone, Apple Maps is in - although consumers will still be able to access Google's mapping service through a mobile Web browser, a method that analysts describe as rather clunky compared to an app. Reaction to the change was swift and often highly critical. Users complained about the iPhone's inability to navigate by voice, and also that Apple map searches pull up wrong cities, wrong streets, and incorrect destinations if they're not spelled out 100% perfectly (Google Maps can deal with misspellings or variations). Even certain towns are not featured on the map. This is creating a problem for Apple and it is something the company will have to sort out sooner rather than later.

Angry Birds-maker Rovio Entertainment will be hoping to prove it's no one-hit wonder when it launches Bad Piggies on September 27th, just as players seem to be tiring of the game they've been addicted to for the past three years.

Here is a quick update on the sad realities of the USA's distorted economy.

Peter Schweizer, founder of the Government Accountability Institute recently stated:

"In the United States now, the city with the highest per capita income in America is Washington, DC. They passed Silicon Valley last year. Seven of the ten wealthiest counties in America are counties that border Washington, DC, so government has become big business. There's a lot of money to be made. And not only is that leading a lot of young and talented people into influence-peddling in industries where I'd rather have them doing something more productive, it's also changing the entire incentive structure. We know for example now that if you look at hedge funds, hedge funds that invest in lobbyists and make a lot of campaign contributions actually consistently outperform those hedge funds that don't. It's not because they're smarter – it's because they're getting access to information in terms of legislation or trends that gives them a leg up. So I think that's extremely troubling, and it's distorting the entire nature of our free-market economic system."

Personally, I have had a wonderful month of September. Rebecca and I got married on September 1st in the Santa Ynez Valley and went on our honeymoon to Moorea, Tahiti. The wedding was amazing and the honeymoon was just as good. If you ever have a chance to go to French Polynesia I certainly recommend it. Rebecca and I are now back in Santa Barbara and happy as can be. I have posted a few pictures below from our honeymoon.