A lot of people are confused about bonds, so I thought I would put forth an example that I hope will explain it for people.
Most everyone has a general idea about how rental houses work. You know, for instance, that someone first buys the house, then rents it out and hopes to collect rent money. They hope to receive a yield on their investment.
So here's the example. I'm going to use simple numbers, which probably won't reflect the rental information in your area, but I want to keep it simple. We're going to really keep it simple - no taxes, no mortgage, no insurance, nothing except the bare necessities.
- I buy a house for $100,000. I invest $100,000.
- I rent the house for $1,000 per month.
- In 12 months (1 year), I collect $12,000. I receive $12,000 from my investment.
- In 1 year, I made $12,000/$100,000 or 12.00% return on my investment.
Now let's look at a slightly different investment. My investment will cost me twice as much ($200,000 instead of $100,000), but I will still receive the same amount of $12,000 per year. I'm receiving less return on my investment.
- I have to invest $200,000 instead of $100,000. I invest $200,000.
- I rent the house for $1,000 per month.
- In 12 months (1 year), I collect $12,000. I receive $12,000 from my investment.
- In 1 year, I made $12,000/$200,000 or 6.00% return on my investment.
Now a final example. I only invest half as much, $50,000 instead of $100,000. I will still receive the same rent return of $12,000 in a year.
- I have to invest $50,000 instead of $100,000. I invest $50,000.
- I rent the house for $1,000 per month.
- In 12 months (1 year), I collect $12,000. I receive $12,000 from my investment.
- In 1 year, I made $12,000/$50,000 or 24.00% return on my investment.
Investment.....Received.....Yield or Rate of Return
$50,000 .........$12,000.......24.00%
$100,000........$12,000.......12.00%
$200,000........$12,000.........6.00%
Notice as the investment cost goes up, the yield or rate of return goes down. It's costing me more, but I'm not getting any increase in the dollars I receive in return, so my yield or rate of return is going down.
Bonds are auctioned with a yield, or Rate of Return. The yield is the same, but the price you pay for the bond can vary because of the auction. That means the Rate of Return will vary based on the amount you pay for the bond.
In the house rental example, you are buying a yield. The yield you are buying above is the rental income of $12,000 per year. However, you are paying different amounts for that yield ($100,000, or $200,000, or $50,000). The amount you are paying is different, but the payment to you remains the same, so your rate of return is different.
- If, as above, you pay more for the bond, your yield, or rate of return will go down. If you paid $200,000 for the house and it paid you $12,000 per year instead of paying $100,000 for the house, then your yield after receiving $12,000 on an investment of $200,000 is less than it would have been if you had only paid $100,000.
- If you pay less for the bond, your yield or rate of return will go up. If you paid $50,000 for the house and it paid you $12,000 per year instead of paying $100,000 for the house, then your yield after receiving $12,000 on an investment of $200,000 is more than it would have been if you had to have paid $100,000.
You can buy bonds in different ways. You can buy them from a bank, or you can buy into a Bond Fund, such as an ETF. Since you can buy them, then you can also sell them.
The price of bonds fluctuates day-to-day with the auction process. That means the value of your bond changes. The payment you receive will stay the same, but if you have a bond and decide you need to sell it, and you paid $100,000 for it, but now the market says it is only worth $90,000, then you will lose money on it if you do in fact sell it - you will lose $10,000. $100,000 (purchased) minus $90,000 (received from the sell): $100,000 - $90,000 = $10,000 loss.
When someone creates a bond, they are creating an IOU. They are exchanging the IOU for dollars. They have to pay interest on the IOU in exchange for the use of your dollars.
The US Government's Department of the Treasury creates bonds known as Treasury bonds (or Treasuries).
At the time I write this, the Federal Reserve of the US Government's program known as Quantitative Easing II (QE2) will end on June 30, 2011. Under QE2, the major buyer of Treasuries has been the Federal Reserve. When QE2 ends, the Federal Reserve will no longer be buying Treasuries. Instead, the open market (other nations, big banks, you, me...) will be the buyers.
Since the major buyer is leaving the market for Treasuries, there will be a reduction in the demand for Treasuries. We all know from Economics 101 that reduced demand means lower prices.
As we say from the rental house example above, lower prices means higher yields. So the Dept of the Treasury will be receiving less money in return for the bonds it is selling. This is the same as paying a higher yield, or higher expenses. So the cost of borrowing money via selling bonds is going to go up for the US Government.
If it's going to cost the US Government more, then that means it's going to cost you - the taxpayer - more.
If you already own bonds, and you need or want to sell them after QE2, then you are going to have to match the current going yield investors expect to receive. That means you are going to have to lower the price you are willing to receive in exchange for your bond. The value of your bond is going to go down, as it has to be since the yield is going up on the bonds the Treasury is creating.
Since the US Treasury bonds are considered the most safe investment available (well...we haven't defaulted on any yet), other things are going to start going up. A simple example - Certificate of Deposits (CDs), issued by banks, will have to increase in yield in order be attractive against the Treasury's bonds.
The price of bonds fluctuates day-to-day with the auction process. That means the value of your bond changes. The payment you receive will stay the same, but if you have a bond and decide you need to sell it, and you paid $100,000 for it, but now the market says it is only worth $90,000, then you will lose money on it if you do in fact sell it - you will lose $10,000. $100,000 (purchased) minus $90,000 (received from the sell): $100,000 - $90,000 = $10,000 loss.
When someone creates a bond, they are creating an IOU. They are exchanging the IOU for dollars. They have to pay interest on the IOU in exchange for the use of your dollars.
The US Government's Department of the Treasury creates bonds known as Treasury bonds (or Treasuries).
At the time I write this, the Federal Reserve of the US Government's program known as Quantitative Easing II (QE2) will end on June 30, 2011. Under QE2, the major buyer of Treasuries has been the Federal Reserve. When QE2 ends, the Federal Reserve will no longer be buying Treasuries. Instead, the open market (other nations, big banks, you, me...) will be the buyers.
Since the major buyer is leaving the market for Treasuries, there will be a reduction in the demand for Treasuries. We all know from Economics 101 that reduced demand means lower prices.
As we say from the rental house example above, lower prices means higher yields. So the Dept of the Treasury will be receiving less money in return for the bonds it is selling. This is the same as paying a higher yield, or higher expenses. So the cost of borrowing money via selling bonds is going to go up for the US Government.
If it's going to cost the US Government more, then that means it's going to cost you - the taxpayer - more.
If you already own bonds, and you need or want to sell them after QE2, then you are going to have to match the current going yield investors expect to receive. That means you are going to have to lower the price you are willing to receive in exchange for your bond. The value of your bond is going to go down, as it has to be since the yield is going up on the bonds the Treasury is creating.
Since the US Treasury bonds are considered the most safe investment available (well...we haven't defaulted on any yet), other things are going to start going up. A simple example - Certificate of Deposits (CDs), issued by banks, will have to increase in yield in order be attractive against the Treasury's bonds.
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