Banjo's Insight - Bonds

Yesterday I posted an article about "Pocket Swapping", which had some information about bonds in it.

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.

Banjo's Insight - Pocket Swapping

For insight into bonds, see this post.

I just can't get my arms all the way around this problem.  I think that's because it must be a circle.  I start off in one direction, go all the way around, and end right back where I started from.

The US Treasury has been writing IOUs in the form of Treasuries (bills, notes, bonds - however you want to think of them).  They need someone willing to buy those bonds.  Sometimes other nations, like the Chinese, buy these bonds.  Sometimes big banks do.  Sometimes poor little wage earners buy them.  Anyway, the US Treasury sells these promises to pay interest in exchange for the money they receive.

I like to think of this as the US Government (Treasury Dept), using it's left hand, pulling bonds (IOUs, notes) out of their left pocket and waving them around in the air while yelling "Bonds for your cash!  IOUs for your cash!  Notes for your cash!"

Meanwhile, the US Federal Reserve, in the form of QE1, then later QE2, is printing money to buy these bonds!  I like to think of this as the US Government (Federal Reserve), printing money and placing it in it's right pocket.  Anytime it wants to buy something, it prints more money and places it into the right pocket.  It reaches into this right pocket, pulls out a wad of cash, and buys US Government (Treasury) Bonds!

Sit back and think about this for a minute.  The US Government, wearing a pair of bib overalls, has a wad of notes for sale that it prints and keeps in its left pocket. The US Government also has a wad of cash that it prints and keeps in its right pocket.

When the time comes that the US Government (Treasury) wants more cash to buy more stuff, it pulls out a wad of notes from its left pocket, then reaches into its right pocket and pulls out a wad of cash, and then exchanges them - it moves the cash from the right pocket to the left pocket, and the notes from the left pocket to the right pocket.  So now the US Government's (Treasury) left pocket is full of money, whereas before it was just a bunch of IOUs.  Meanwhile, the Federal Reserve, which had money in its right pocket, now has a wad of IOUs instead.

Betcha didn't know that, didja?

So, the US Government, printed cash and exchanged it for IOUs that it also printed.  It manufactured money!  Guess who has to pay off all those IOUs?  You've got it - the American Taxpayer.

But isn't that a lot of debt?  Yes - I saw some reports this week that said it amounts to $500K per household.  That sounds crazy to me, so I don't know.  But moving stuff around in pants pockets and calling it business sounds crazy too!

We all know about supply and demand.  If we've got too high a supply of something, then the price of that thing falls.  If we've got too high a demand for something, then the price of that thing rises.  With that understanding, let's look at the pocket swap.

The  US Government (Treasury) has been printing all the IOUs that it can print.  All those little fingers have been busy over at Treasury!  With so many IOUs being printed, then there must be an oversupply, so this means, as we noted above, that the price must surely fall.  But!  As it turns out, the demand for these Treasury notes/bonds/IOUs is even higher than the supply!  Yup - the demand from the US Government (Federal Reserve) is even higher than the supply from the US Government (Treasury)!  Why, the demand is so high, the prices have been rising!  And rising bond prices means low interest rates!  Yup!  That's the way bonds work!  So the interest rates the US Government (Treasury) has had to pay in order to obtain the cash has been held down because the demand is so huge!

So, the US Government (Treasury) has been printing IOUs, and the demand from the US Government (Federal Reserve) has been insatiable, so the amount of interest being paid on this debt has been low!  What a deal!  The more bonds/notes/IOUs the US Government (Treasury) has been printing, the less it cost them in interest!  Wow!  Is that slick, or what?

What happens to the value of our dollar?  We just went from $100 dollars to $200 dollars because we printed up a bunch of them.  They got pushed into the market place.  The good 'ol USA just doubled the amount of dollars it has!  We are twice as wealthy as before!  Yippee - ain't it grand, ain't it great!  Oh, wait - dang; that's what we did during the Vietnam war under President Johnson - printed up a bunch of dollars that were suddenly chasing the same amount of goods - twice as many dollars, same number of things for sale - why, heck - I remember prices going way, way up before Reagan kicked Carter's ass out of office and killed inflation!  So all this printing, won't that lead to a bunch of inflation?  Oh hell no.  That's not going on, why I just bought a tank of gas for my truck....dang, why did that cost more again?  Well, anyway, I just bought some produce and ... dang, why zakly did that cost more again?  Heck, that's not inflation - that's just prices going up - don't have nothing to do with inflation.

All that printing of IOUs and dollars - that was what has been going on with QE1 and QE2 (Quantitative Easing - the pocket swap deal).  Now the US Government (Federal Reserve) is saying, "we aren't going to do QE3", and that means - tadah - no more pocket swap deal!

But the US Government isn't suddenly going to stop needing money!  Not with all those people with those great big salaries and benefits - it is still going to need more money then it is collecting in taxes.  So it's going to continue printing IOUs.  Only now, instead of the buyer being the other pocket of the same government, it's going to be other governments (China?), other people.

So, see, we're going to sell all these IOUs to other people, other nations.  But isn't that what Greece was doing?  Spain?  Portugal?  Italy?  Selling a whole lot of IOUs while they had a really, really good time?  Aren't some of those IOU customers, like China, getting a little wary of IOUs?

Well, China is complaining, so maybe they are!  They are complaining that the US Government is devaluing the US Dollar by printing so many of them.  And they are complaining that this means the US Dollars they hold will be worth less, and the debt they hold will be worth less.  And if there's one thing a communist country appears to know, it's what the US Dollar is worth, and they appear to be complaining.  Why, they are even talking about getting rid of the US Dollar for international exchange!  Well, aren't they a bunch of party poopers?

But we'll fix them!  We won't do QE3!  Hah!  We won't be buying no more stinking wads of IOUs from our left pocket with our freshly printed dollars in our right pocket!  Hah!  We'll just quit buying our IOUs with OUR dollars!

But won't that mean the supply is going to jump way up, because we are removing a whole-damn-load of demand from the auction?  Well, I expect!  We're just going to take our demand and go home with it, leaving that old US Treasury to sell all those IOUs to those other suckers.  Course, with the excess supply, the price is going to drop, yup.  And, with the drop in the prices the Treasury can get for the sale, why - they're going to have to pony up to pay more in interest on those IOUs.  Yup.

So that debt, it's going to get harder to pay?  Yup.  It's going to cost more to pay that debt.

Are you telling me that the amount of debt is going to get bigger, and at the same time, the interest is going to get bigger, so the taxpayer is going to have to pay a whole lot more, just like in Greece, where they are having riots?  Yup.

Well, that sucks, for sure.  But we can depend on our politicians, because they are going to get us out of this - they are all smart, just like Senator Weiner.

Well, let me see.  The debt is getting bigger, and its going to cost more to pay it off, right?  Yup.

So we're going to tax everyone more, right?  Well, you see, that's going to be kinda hard; notice how hard it is over in Greece?  Over in Spain?  They don't appear to be happy about lower wages and higher taxes.

So I don't think our politicians are going to do that.  And if they don't do that, then there is only one other solution: to inflate the debt away.

So, just how, zakly, does one go about inflating the debt away?

Let's talk about buying a car and taking out a loan to buy it with.  Remember President Johnson printing all of those dollars for Vietnam, and the inflation?  A new Ford Fairlane 500 car with air conditioning and 396 CU Inch motor in 1967 was $3,600.00  By the time inflation was finished, a new car in 1981 was going for $12,000.  So inflation meant you had to have a whole lot more dollars to buy the same thing.  So, somehow, from 1967 to 1981, or 14 years, a car cost more than 3 times as much.

In 14 years, people would have thought paying $3,600 instead of paying $12,000 was a bargain!  Yet, because of inflation, they were the same thing.  A debt of $3,600 in 1967 was  about the same thing as a debt of $12,000 in 1981.  That debt of $3,600 got a whole-lot-cheaper, and it got cheaper because we were paying it with cheaper dollars.

So what does this have to do with the debt we have incurred under QE1 and QE2?  Our politicians can't tax this amount of debt - it will mean they get voted out of office.  So the only solution left to them is to inflate the dollar, so the debt gets cheaper.  And while the debt is getting cheaper, the dollar is getting cheaper, and the salaries are going up, and more taxes are coming in from the increased salaries, and the debt is getting cheaper, and everybody is happy happy happy!

Except, of course, retired people that can't earn higher salaries.  They are going to get squeezed out.  Everything is going to get more expensive.  And that $250,000 they socked away for retirement, why that might not even buy a used car.

So, by not having QE3, we're going to have inflation?  Yup, because we can't afford the debt.  And if we have QE3 we're going to have inflation?  Yup, because we are printing more dollars.

And what's going to happen to the debt?  We are going to inflate it away.  And it's going to ruin some people.