Investment Workshop 22: Interest Rates and Bonds

Wanderer
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Wanderer

The Wanderer retired from his engineering job at a major Silicon Valley semiconductor company at the age of 33. He now travels the world, seeking out knowledge from other wealthy people, so that he can teach people how to become Financially Independent themselves.
Wanderer
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Hello again and welcome back to the Millennial Revolution Investment Workshop! New readers, please click here to start from the beginning.

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Status

Before we begin, I thought I’d give a fun little update on how our portfolios are doing. When I logged into my trading accounts to calculate our next round of buy orders, I realized that after adding up capital gains from rising stock markets and distributions from dividends and bond interest, we have now made about $100 in each account!

Portfolio Currency Book Value Market Value
Canadian CAD $5,000 $5,104.50
American USD $5,000 $5,098.65

We made this workshop free because we believe knowledge of how to invest should be a human right and not just held exclusively by the rich.

But NOW, as it turns out, if you have been participating and copying our moves from the start, instead of COSTING you money like every other online course offered by your average financial blog, with our Workshop not only have you paid us $0, you would have actually MADE $100!

And this is with our relatively small amounts that we’re investing for demo purposes ($1000 a month). If you’ve been copying our moves but instead investing, say, $5000 a month, you would have made $500. If you had been investing $10000 a month, you would have made $1000. And you would actually understand why it’s working, rather than just shrugging your shoulders trying to understand your confusing-ass 401(k) statement.

But if you haven’t been participating or you found us only recently, well no time like the present to get started! Studies have shown that for passive buy-and-hold investors like us, the single biggest determinant of success is time in the market, rather than timing the market. The (brief) history of this workshop is a testament to that. When we started our buys, Trump had just been elected and every investing instinct told me to hold off and wait for the inevitable stock market crash that literally EVERY pundit predicted. However, that would have been timing the market, so I ignored that instinct and started buying anyway. And because I did that, we made money.

*mic drop*

*remembers there’s still more to this article and picks up mic again*

And Now to Bonds

If you’ll recall, the two major components of a portfolio are equities (or stocks), and fixed income (or bonds). And bonds are, to put it simply, kinda sorta complicated. Not that stocks are simple, but everyone generally understands that when stocks go up, that’s “Good”, and when stocks go down, that’s “Bad”.

Bonds? Not so simple. It actually took me some time to finally wrap my head around bonds, and here’s what I learned.

Central Banks Don’t Determine Interest Rates. The Bond Market Does.

Whenever central banks do something, it makes headline news. The Federal Reserve raised interest rates by a quarter point! The Bank of Canada dropped interest rates by half a point! Always in exclamation remarks, because it’s such a BIG FUCKING DEAL, but what does it actually mean?

The Central Bank (of whatever country) is responsible for issuing debt on behalf of their respective government. They issue short term debt called Treasury Bills (which mature in less than a year), medium-term debt called Treasury Notes (maturing between 1 and 10 years), and long-term debt called Treasury bonds (maturing between 10 and 30 years). Each of these takes your money, pays an interest rate than the Central Bank decides, and then give you your original money back at maturity. Simple, right?

And this is when the Bond Market, meaning the aggregate of every bond trader out there, takes one look at the interest rates that the Central Banks are offering and collectively go, “Nah, we’re going to decide what the interest rate REALLY is.” This is because bond traders can decide how much they’re willing to pay for a certain issue.

Think about it. If the US government offered you a $1M 30-year bond paying 5%, and the Greek government also offered you a $1M 30-year bond paying 5%, which would you pick? Obviously the US one. But what if you could get the Greek one for only $800k? $500k? $200k? Hmmmm, maybe you might be tempted at that price. Because if the Greeks actually pay that bond (using German Euros, probably), you would be getting an effective yield of ($1M x 5%) / $200k = 25%.

What you just did (as an imaginary bond trader) is you evaluated the quality of a certain bond (in this case, Greek debt) and assigned an effective yield on a debt instrument completely ignoring what the underlying issuer intended. This is what the Bond Market does.

This happens to all bonds. The bond issuer offers a certain interest rate, then bond traders decides what it’s REALLY worth, and that is, essentially, the Bond Market.

What you’re looking at is the current US Treasury Yield Curve. It shows what each Treasury maturity is currently yielding, meaning how much each issue is selling for in the Bond Market.

I have stared at so many charts like this, you would not believe. Bond Traders fucking LOVE charts. I wouldn’t be surprised if one of these guys show up on the news getting arrested trying to build a sex doll out of printed out Powerpoint presentations.

But because that curve reflects the opinion of every bond trader on the planet, once you learn to read those charts you can actually learn quite a bit. For example, based on the shape of that curve above, you can actually predict when a recession will occur. By taking yield curves from one asset and comparing them to other yield curves from other assets, you can actually predict things like inflation and the likely future direction of the stock market. And by taking yield curves of one country and comparing it to another, you can predict whether a country will likely collapse. It’s pretty cool stuff, and I may cover it in a future article if people are interested.

And in case you were wondering, the yield curve above suggests an economic expansion underway.

When Interest Rates Change, Your Yield Doesn’t…

So how does this affect investors? If I own a bond, and I see a news story about interest rates falling, does that mean my interest rate drops?

Nope.

For the most part, anyway.

There are some assets like Rate-Reset Preferred Shares that DO change up or down with prevailing interest rates, but for most plain-vanilla government bonds, your yield is locked in when you buy it. You bought that Greek $1M 5% bond at $200k, so you will be receiving $50k a year or 25% annually no matter what interest rates do from here on in (unless they default, of course).

…But Bond Values Do

And here’s where things get confusing. If I own a bond (or a bond ETF, as we advocate in these here Workshops) paying 5%, and interest rates change for whatever reason so that the same maturity is now yielding 4%, then how much is my bond worth? Turns out MORE. But why? Interest rates went down!

Here’s a rule I came up with to understand the madness.

Prevailing interest rates determine the yield for NEW MONEY coming into the market.

So if you have a fistful of money and you’re thinking of buying bonds, when interest rates go down you go “Aw, shucks!” because now your dollars would yield less if you bought that bond. But if they go UP, you go “Woohoo!” because now your dollars can buy more valuable, higher-yielding bonds.

Which brings me to my second rule.

Bond prices go in opposite directions of interest rates for EXISTING bondholders.

What do I mean by that?

Pretend you’re holding a $100k 30-year bond paying 5%. Now imagine interest rates move so that 30-year bonds now only pay 4%. Would you sell your $100k bond for $100k? Of course not! People with cash can no longer get 5% anymore! They can only get 4%. So you would only sell your bond for a higher price, such that the person with cash is only getting 4% on their money.

Basically, because interest rates went DOWN, your bond went UP in value.

So basically, this is how interest rates affect bonds.

If You… And Interest Rates… You are…
WANT Bonds RISE 🙂
WANT Bonds FALL 🙁
HAVE Bonds RISE 🙁
HAVE Bonds FALL 🙂

Now Back To Business

And on that note, because we are on one of our regularly scheduled buy days, we shall now commence our next buy.

Canadian Portfolio

We start by getting a snapshot of our current holdings (including new cash)…

Asset Ticker Unit Price Units Market Value Allocation Target Allocation
Canadian Bonds VAB $25.64 72 $1,846.08 36.08% 40%
Canadian Index VCN $31.81 29 $922.49 18.03% 20%
US Index VUN $43.84 21 $920.64 17.99% 20%
EAFE Index XEF $28.39 26 $738.14 14.43% 16%
Emerging Markets XEC $24.69 7 $172.83 3.38% 4%
Cash $1.00 516.14 $516.14 10.09% 0%

Then we figure out what buys we need to make to rebalance…

Asset Ticker Target Allocation Unit Price Current Market Value Target Market Value Current Units Target Units Difference
Canadian Bonds VAB 40% $25.64 $1,846.08 $2,046.53 72 79.8 7.8
Canadian Index VCN 20% $31.81 $922.49 $1,023.26 29 32.2 3.2
US Index VUN 20% $43.84 $920.64 $1,023.26 21 23.3 2.3
EAFE Index XEF 16% $28.39 $738.14 $818.61 26 28.8 2.8
Emerging Markets XEC 4% $24.69 $172.83 $204.65 7 8.3 1.3
Cash 0% $1.00 $516.14 $0.00 516.14 0.0 -516.1

And finally we decide the actual unit numbers, making sure not to go into margin.

Asset Ticker Unit Price Action Fractional Units Units Proceeds
Canadian Bonds VAB $25.64 BUY 7.8 8 $205.12
Canadian Index VCN $31.81 BUY 3.2 3 $95.43
US Index VUN $43.84 BUY 2.3 2 $87.68
EAFE Index XEF $28.39 BUY 2.8 3 $85.17
Emerging Markets XEC $24.69 BUY 1.3 1 $24.69
Total $498.09

American Portfolio

And for our American readers, we start similarly by getting a snapshot of our current holdings (including new cash)…

Asset Ticker Unit Price Units Market Value Allocation Target Allocation
Bonds BND $81.37 23 $1,871.51 36.71% 40%
US Index VTI $120.99 11 $1,330.89 26.10% 30%
International Index VEU $47.67 29 $1,382.43 27.11% 30%
Cash $1.00 513.82 $513.82 10.08% 0%

Then we figure out what buys we need to make to rebalance…

Asset Ticker Target Allocation Unit Price Current Market Value Target Market Value Current Units Target Units Difference
Bonds BND 40% $81.37 $1,871.51 $2,039.46 23 25.1 2.1
US Index VTI 30% $120.99 $1,330.89 $1,529.60 11 12.6 1.6
International Index VEU 30% $47.67 $1,382.43 $1,529.60 29 32.1 3.1
Cash 0% $1.00 $513.82 $0.00 513.82 0.0 -513.8

And finally we decide the actual unit numbers, making sure not to go into margin.

Asset Ticker Unit Price Action Fractional Units Units Proceeds
Bonds BND $81.37 BUY 2.1 2 $162.74
US Index VTI $120.99 BUY 1.6 1 $120.99
International Index VEU $47.67 BUY 3.1 3 $143.01
Total $426.74

WORKSHOP TOOLS:


How much does it cost to participate in this investment workshop? NOTHING. Because that's how we roll. All we ask is that you sign-up using the following affiliate links to keep it free forever:


For Canadians:
Questrade

For Americans:
TD Ameritrade
Personal Capital


Disclaimer: The views expressed is provided as a general source of information only and should not be considered to be personal investment advice or solicitation to buy or sell securities. Investors considering any investment should consult with their investment advisor to ensure that it is suitable for the investor’s circumstances and risk tolerance before making any investment decisions. The information contained in this blog was obtained from sources believe to be reliable, however, we cannot represent that it is accurate or complete.

22 thoughts on “Investment Workshop 22: Interest Rates and Bonds”

  1. Very good explanation Wanderer. Of course we want to hear more about the prediction possible to make using the bond charts.
    A comment though. I don’t like the idea of time in the market beats timing the market. If you invest for long term it might be true but that’s not the case if you need that cash within 10 yrs from now. If you simulate the entry point of a big lump in several periods of time, not necessarily one before a crash but one before a long period of economic stagnation you’d be screwed ! Careful with this idea because not everyone is a buy and hold’er in the market !

      1. So, I cannot be a trader and invest/speculate to achieve FI as well? I think the biggest problem w/ FIRE community is to believe in a single way of doing things. There are a couple of ways and if you’re experienced enough w/ the market you can even day trade and succeed using risk management techniques and charts (technical analysis). I just want to keep my mind open !

        1. Well said Mark. Totally agree with you that all of us should keep an open mind. All roads lead to Rome.

          You definitely can achieve FI by being a trader/speculator.

          The traditional stock + bond combo still works sometimes, but in my humble opinion is less ideal nowadays because stock and bond are not always negatively correlated.

          The theory of stock + bond is old school and can trace back decades ago. Using this kind of strategy is like…doing calculations with pen and paper. I’m not saying pen and paper don’t work, they still do the job fine, but hey we got calculators and computers now. In today’s fast changing world, I think it’s important to adapt changes and innovations, or you become obsolete.

          Although I haven’t had much luck “timing the market”, I’ve been just simply buying lows and selling highs, meanwhile using options to hedge my positions. It’s a lot more work than passive investing, but so far it’s working for me.

          Good luck trading/investing!

        2. It’s not born out of a “my way or the highway” arrogance. I just no longer believe individual investors can make money consistently being a day trader anymore. There are too many high-frequency traders and institutional investors with inside knowledge for retail investors to compete with. Long-term buy-and-hold passive investing is the only way I know to invest successfully that can be reproduced by anyone.

          That being said, if you want to actively trade, go for it. Just keep it to less than 10% of your portfolio so you can’t blow yourself up too bad.

  2. I’ll come back to this post a year from now after the market crashes because of Trump and see if you still have the same conviction about not waiting a more attractive market valuation to invest. P/E ratio of S&P is almost 30, highest in history while the historic average is 15. There is no substantial economic growth to back this up. Won’t put a dime in the market until P/E falls at least below 20. Am I wrong to use fundamentals to back up my investment strategy Wanderer?

    1. Hey, nobody’s been predicting a Trump crash harder than me, but I didn’t trade on that prediction and no markets are up.
      In my investing career, when you’re looking for an entry point it’s always either
      1) The markets are overvalued. You’d be an idiot for jumping in.
      2) The markets are crashing. You’d be an idiot for jumping in.

      It’s literally NEVER “Yeah, markets are fairly valued and the economy is doing well. Now would be a good time to buy.”

      1. Well, OK. We’ll come back to this next year ! I would at least use DCA ou even better, Value Averaging. Would never put a lump sum in a market like this but that’s fine. Everyone knows where it hurts

  3. Nice explanation of bond pricing! I’ve spent a lot of white board marker explaining this to friends. It all comes down to, “how much are you willing to pay for cash flow”.

    I find the most success using real estate as an analogy. People just understand paying rent better than bond coupons and dividends.

    Thank you for this workshop, it’s providing lots of good insights!

  4. Great post Wanderer! Don’t forget to link it into the Investment Workshop tab where I think a lot of your readers may be expecting it.

    We look forward to next week when you explain the magic of the treasury curves.

  5. Hi Wanderer

    Great article – as always. You and Firecracker are a great writing combo.

    I’d be interested in learning more about economy crash / inflation predicting that you mentioned above.

    And as I’m an Aussie, living in Australia, in terms of portfolio starting should I be looking to go into the US portfolio you’ve setup? Or would you recommend the Canadian? Sorry – just wondering which portfolio will be better (easier etc) for an international investor.

    Cheers A

    1. I don’t know much about the Australian investing environment, but as a starting point I’d take the Canadian one and swap out the Canadian ETF with an Australian Index ETF. Your economy’s a lot like Canada’s. Heavily resource based, and dwarfed by the Americans.

  6. Never been a huge fan of bonds, despite my 401k being 20% bonds. I’ve said in the past that dividend stocks were my favorite investment, simply because I like owning a company whose inherent value increases. Your dividends grow; your fixed income is FIXED. And some of the multinationals are as safe as any country. It’s very difficult to lose money–to REALLY lose money–investing in Coca-Cola or Colgate-Palmolive.

    And by writing this, Wanderer, you can be convinced of my lack of sexual deviancy. Making blow up dolls out of PowerPoint presentations is definitely a bond trader thing. Us dividend investors have sex with actual humans.

    Sincerely,
    ARB–Angry Retail Banker

    1. I have actually looked seriously into dividend investing as a strategy, and if I were American I probably would have done what you did.

      In Canada, dividend investing will concentrate you in just a few sectors: energy and financials. So a dividend investor in Canada is not actually all that diversified, and can get whacked hard by an oil crash (like the one that just happened). And it makes no sense to try to dividend-invest outside Canada because we lose our tax advantages.

      But as an American? You guys are a LOT more diversified if you just stuck with dividend aristocrats. You’ve got energy, telecom, finance, health care, consumer staples, etc. AND you get the tax advantages. Your dividend aristocrats are one of the VERY few areas where I envy you guys 🙂

  7. “But because that curve reflects the opinion of every bond trader on the planet, once you learn to read those charts you can actually learn quite a bit.”

    The Central Bank issues short term bills at low interest rates and buys notes and bonds at higher interest rates thereby flattening the yield curve. Every bond trader on earth bows to the all powerful Federal Reserve. Try betting against their $4.2 trillion USD balance sheet.

  8. Great post, Wanderer!

    I especially liked the happy face chart. Makes it easy on those of us whose brains start to seek out shiny distractions near the end of an article on finance, heh.

    Still waiting on you to share that spreadsheet for spitting out buy orders too, 😀

    1. Yeah, I figure a topic like bonds needed less charts and more happy faces. That’s the only way I was able to understand it.

      And yes, still going to share that buy order calculator but I need to clean it up and make it presentable to public consumption first. Once that’s done I’ll put it up.

  9. Another excellent post Wanderer. You make economic sounds so interesting. You and Firecracker make an excellent writing duo. I would like to read more on the economy crash / inflation predicting that you mentioned above. Looking forward to your next investment workshop.

  10. @Wanderer: it is actually the US Treasury Department (a government agency) that issues Treasury bonds and bills, not the Federal Reserve (which is true for any developed nation). The Federal Reserve is in theory independent from government. However, the Fed has been buying these Treasury bills and bonds to keep interest rates low – and has therefore become an incredible market force that IS setting both short- and long-term rates.

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