Say you are looking to invest in a 10-year Treasury bond that pays a coupon rate of 5 percent. So if you invest one thousand dollars, you’ll get 50 dollars in interest each year for the next 10 years. And when the bond matures at the end of that 10-year term, you’ll get your original $1,000 investment back.
Now say the day after you buy that bond, market interest rates rise by 2 percent. A new bond now fetches 7 percent.
No big deal for you though as you are happy collecting the 50 dollars in interest each year from the bond you already own.
But say your best friends are going to Hawaii and you don’t want to miss the fun but you are short on cash. The money tied up in that bond would really come handy.
So you decide to sell that bond. You intuitively know that you are not going to get the price you paid for it because prevailing interest rates are now higher. Why would anyone care to buy your bond that pays 5 percent interest when that anyone can buy the same bond in the open market that pays now 7 percent.
To sell that bond then, you’ll have to discount its price to a point where the yield matches prevailing interest rates. That new price would be around 700 dollars. You just lost 30 percent in value buying the safest of all investments because you didn’t plan your purchase right.
The opposite is also true. If market interest rates declined by 2 percent instead of rising, that $1,000 bond you own will now be worth $1,700 if you choose to sell it.
And you’d want that outcome if you are retired and not investing new money. But if you are a young yuppie investing through every paycheck, you’d want to buy more income each time you invest. You want prices to be lower and yields to be higher. You want any new bond you buy to pay you 7 percent instead of 3 percent.
Think of stocks the same way. Coupon payments from stocks are the profits the businesses behind those stocks make. The only thing different is that coupon payments from stocks (profits) are unpredictable and can rise or decline due to company-specific, sector-specific or economy-wide issues. Coupon payments from bonds are more or less fixed and guaranteed.
The edge with stocks though is that in the long run, their coupon payments grow as business profits grow.
So if you are in the market to invest new money, you want that money to buy more coupon payments (cash flows) than less. Which means you want lower prices for investments and not higher.
No one likes lower prices though but lower prices is what you should want.
Thank you for your time.
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