No Yawning Please

Got an audience? Want to put them to sleep? Talk of interest rates will do the trick every time. This is a tad ironic as this topic impacts all of us personally.

World markets trade bonds just like anything else. There is a key relationship between price and interest rate. Let’s start there.

Assume that company A wishes to borrow and issues an IOU, a bond ($1000 minimum denomination). Assume lenders require A to pay a 6% coupon for that loan, or $60/yr, say for 10 years. Now assume over the next 12 months economic conditions slow so that when B, an identical credit to A needs to borrow, B needs only to offer 5% to acquire the funds. But assume you are a holder of bond A and wish to sell after one year. Will you ask only $1000, face value? Naturally not as the interest rate associated with similar credits to A is now 5%. Instead you will price your bond at $1200, making the attached coupon of 6% worth 5%, or the market rate. Nice little profit.

Instead of general conditions, there may be some extraneous factor(s) which make A’s bonds attractive - say a cure for cancer. Thus investors will drive A’s bond price up steeply and quickly even though the general interest rate environment has not changed.

Thus, interest rates down, prices up. Or, interest rates up, prices down. That’s all there is to it.
Conditions of individual bond pricing are far more complex but it is only necessary for most of us to understand this simple relationship or axiom to acquire a long leg over most laymen.

Now let us look at the current situation, at the US instead of company A as a borrower. Given the latest world financial turmoil large investors (China, Saudis, St of Cal pension, college endowment funds, etc) seek shelter. The safest place to shelter one’s funds is in short-term US treasuries. This tremendous demand, something we call "flight-to-quality" (could be a cure for cancer) has driven treasury prices through the roof. And so we know that yields must correspondingly take a nose dive. They have. The yield on 90 day treasury bills is 0.02% for goodness sake. So in a bit of a twist the US is paying next to nothing to finance the billions in rescue packages orchestrated in Washington.

Robert Craven