Are you financially literate?

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sighyoung
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Re: Are you financially literate?

Post by sighyoung »

lukethedrifter wrote:
Michael wrote:
If interest rates rise, what will typically happen to bond prices? Rise, fall, stay the same, or is there no relationship?
[SHOW]
Answer: fall
For most households I think the bonds question is most likely relevant if you ever have the opportunity to pay down a mortgage early. Conceptually, a mortgage is a bond you issue (The question above assumes the opposite - you're the buyer not the issuer). Therefore, when interest rates rise your mortgage becomes more valuable.

For example, let's say you have a 100k mortgage at 4% interest and low money markets are paying 1% interest. If you're trying to decide where to place an extra $500 a month a guaranteed 3% (4%-1%) return might appeal to you*. However, if interest rates increase and money markets start paying 5% you'd be crazy paying down a 4% mortgage instead of investing in the money market. Investing in the money market gives you 1% better returns than paying off the mortgage early. As you can see in a high interest rate environment your mortgage is a valuable piece of debt and your mortgage company would love for you to pay it off early because they'll be able to get better returns elsewhere.

*For simplicity I'm not going to discuss taxes, liquidity concerns or alternative investments like stock index funds.
I was following. Until i wasn’t. You’re saying an interest rate rise causes bonds to become more valuable to the issuer. Then why wouldn’t the price rise?
The price does rise on flexible-rate mortgages. Fixed-rate mortgages, however, lock in rates for the entire term of the loan--in many cases, 15 or 30 years, and it's fixed-rate mortgages that Michael is talking about. For instance, my mortgage is 30-year at 3.5% interest--I purposely refinanced when rates were low--while my home-equity line has a flexible interest rate that will continue to rise. Obviously, I would pay off the home-equity line first because of the higher interest rate, but also because the interest rate will continue to rise. Once I do so, I'll have to make a strategic decision about my mortgage--with such cheap debt, does it make sense to pay off early in a high interest-rate environment.

We haven't been in a high interest-rate environment for a very long time. For instance, I kept most of my money in a savings account in the 1980's when I was a grad student, and even with the paltry sums I earned then (stipends of $5500 and $6000 a year), I would net $500 a year in interest. It would be nice to earn that kind of return on savings again--but only if I get rid of high-priced debt at the same time.

AWvsCBsteeeerike3
"I could totally eat a pig butt, if smoked correctly!"
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Re: Are you financially literate?

Post by AWvsCBsteeeerike3 »

My understanding is a bond is an agreed upon IOU where an investor gives, let's say, $100K upfront and gets a promise that he will get that $100K back in some period of time (let's say 10 years) and during that timeframe, the investor will receive the agreed upon rate of the bond (let's say 2.5% or $2500/year). These bonds are sold all the time by the government, so there are a lot of them out there and they are readily available, but the rate changes daily.

If you hold a $100k bond yielding 2.5% and the rates rise to now let's say 5%, the bond yielding 2.5% becomes less valuable because on the open market, investors can get the same deal (give $100K in exchange for the same promise to be repaid and earn the agreed upon rate) but they'll earn $5000/year.

Let's say the original investor with the bond at 2.5% wants to sell that bond in a market where the rates are now 5%. He can still sell it, but the bond isn't going to return $100K. Why would anyone do that as opposed to just buying a bond returning 5%. So, the original bond is discounted to a price where it will yield 5% as well. Which would be $50k (ignoring the return of the $100k upon maturation). Or something like that. Of course, the original investor could simply keep the bond until maturity and earn the 2.5% but the likely downside to that is inflation is going to be eating away at the returns (highlighted by the fact rates have doubled).

And, usually rates won't double like that. They're much more marginal changes. But, as I understand it, that's a decent made up scenario. And, I'm no bond expert, nor do I really ever pay attention, so that may be completely inaccurate.

Michael
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Re: Are you financially literate?

Post by Michael »

My example didn't translate well to the bond question, but I couldn't think of an example that works better. Honestly, I think the bond question is not very important concept for the average investor. Understanding concepts like the time value of money and the magic of compounding interest are waaaay more important.

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