FinanceFinancial Education

Understanding Debt Markets (Bonds, etc.)

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As with our discussion of equities, there is far more than meets the eye when addressing debt markets. Instead of focusing on the agencies and instruments, however, my primary goal is to illustrate how debt instruments react to different influences, how rates are being manipulated, and how that manipulation affects investors.

What do we need to understand about the debt markets?

First, the most common debt instrument is a bond. In a debt transaction, an investor “lends” money to an institution in exchange for future repayment (interest and principal). This is important because creditors are supposed to get paid before owners in the event of liquidation. Unfortunately, as happened with the General Motors bail-out, that is not always the case.

Second, bond values are interest sensitive. As interest rates increase, the value of a bond decreases, and as interest rates decrease, the value of a bond increases. Why? If bond “A” has a coupon (declared interest payment) of 4%, but bond “B” is issued with a 6% coupon, the value of bond “A” would need to decrease so the buyer would be “compensated” for the lower coupon. Due to this dynamic, longer-term bonds are the most susceptible to fluctuations in value.

Who determines interest rates?

Once we understand the answer to that question, we will begin to understand how market manipulation begins. At the highest tier, the Federal Reserve sets foundational interest rates: (1) Discount window – the rate banks pay to borrow from the Federal Reserve to bolster liquidity, and (2) Federal Funds Rate – the rate depository institutions use to trade balances held at the Federal Reserve. At the next tier, banks set the rates. For instance, LIBOR is an average of rates banks use to lend between themselves. They also set their own consumer interest rates. A confluence of market factors influence pricing from there: (1) Interest rates themselves, (2) Inflation, (3) Creditworthiness of the issuer, and (4) Equity market volatility.

Think about those influences…while I address them from the bottom up…

If the equity markets are too volatile or if there is an expectation of a coming correction due to excessive pricing, risk adverse investors will move to the perceived security of bonds. As that happens, demand typically pushes interest rates higher. In addition, issuers with less than pristine credit are often forced to offer higher rates to “buy” business. As inflation increases, so does demand for higher rates, so issuers are forced to compensate accordingly. These are all market-influencing factors, but even these factors are not completely free from manipulation thanks to the massive amounts of money managed by institutional investors. However, the real manipulation begins much higher in the food chain.

Before I continue, I want to address the “perceived security” of bonds. As indicated above, creditors should be paid first in the event of liquidation, but liquidation is not the creditor’s only potential peril. Sometimes an issuer simply defaults. That is where issuer credit ratings become important. To mitigate potential claims paying risk, many municipalities try to bolster confidence by insuring their bond issues. Unfortunately, two of the top three insurers are currently in financial rehabilitation themselves: AMBAC – American Municipal Bond Assurance Corporation, and FGIC – Financial Guarantee Insurance Corporation. The strongest of the three is MBIA – Municipal Bond Insurance Association, with their subsidiary National Public Finance Guarantee.

Back to interest rates… As indicated, rates are first influenced by the Federal Reserve. In addition, the Federal Reserve has created its own market – and satisfied demand – by pushing $85 Billion per month into U.S Treasuries and mortgage-backed securities (think Fannie Mae and Freddie Mac). No manipulation there.

Who is selling those assets to the Fed? Ignoring the fact that Fannie and Freddie were bailed out, who else was bailed out? Hint…think TARP. That right, banks were bailed out. Why? Was it due to credit default swaps and toxic mortgage-backed securities? Are bank reserves growing at the Fed at virtually the same $85 Billion rate the Fed producing? Yes and yes!

So, the Fed influences the rates and then continues to manipulate the rates via bogus asset purchases, which further influence market sentiment that directly impacts U.S. Treasury pricing. Meanwhile, the banks reap the rewards offloading toxic assets. Then, the banks further manipulate interest rates internally between themselves, and finally set consumer rates, which further influences bond rates and pricing. Nope, no manipulation here at all…

The end result of all this manipulation creates considerable uncertainty for the average investor. Rates are too low for meaningful income, and rates will rise, so long-term bonds could be detrimental due to potential decreases in value. That forces otherwise risk adverse investors to seek growth and income in a volatile equity market that is falsely inflated due to the factors just discussed. Unless they are extremely savvy or have extremely savvy advisors, it is virtually a no-win proposition.

Like I said, more than meets the eye… Stay tuned as we discuss mutual funds and style drift.

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