Very confused by Bonds

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anonsdca
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Very confused by Bonds

Post by anonsdca » Mon Oct 09, 2017 9:55 pm

Hello, I have read the wiki many times and I just can't seem to grasp Bonds. I like the idea, but I don't have any. My understanding is that this is debt--a loan to someone where you get interest/coupon/payment and eventually get returned your principal. I like that.

I have only focused/read on Government bonds and that is all I want to focus on at the moment.

1) I read about US Treasury Bills and follow the link to TreasuryDirect and their seems to be noticeable return rates I can grasp onto and they start talking about buy "at auction"! Oh My, seems like too much. These seem to be short term (0-1 YR).

2) I read about Treasury Notes (1-10 Years) seems confusing also. Again, looks like you buy at a discount to Par, and get paid every six months or so.

Are there any safe Bonds, that act like a CD and return more than a CD? I have about $35K, so looks like I can get 2.25% at Ally. Can you do anything better with Bonds? This $35K is not my EF. I have 25 months of that already at CapOne at 1.2%. I really like the idea of this Bond thing but it seems confusing. I would like something that cannot go down in value, so I think that leaves Bond funds out as they can go down?

Thanks

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Re: Very confused by Bonds

Post by z3r0c00l » Mon Oct 09, 2017 10:11 pm

Not sure you can do much better than CDs in bonds that are safe, but you can certainly avoid the complexities of buying your own individual bonds from the government. I suggest a bond mutual fund which owns thousands of different bonds in various proportions to give you exposure to government and corporate bonds in an easy package.

https://personal.vanguard.com/us/funds/ ... IntExt=INT

Yield is 2.39% and that seems decent enough right now. Unlike CDs, you can take out or add money at any time without penalty or breaking up the whole lot.

I would also suggest iBonds.
Last edited by z3r0c00l on Mon Oct 09, 2017 10:14 pm, edited 1 time in total.

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Jerry55
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Re: Very confused by Bonds

Post by Jerry55 » Mon Oct 09, 2017 10:14 pm

You're correct in that Bond FUNDS can go lower, as prices move opposite of Bond Rates (of return). Interest Rate up ? Bond Prices down, in general.

But, that's if you're buying and or selling bonds, coz if you buy a 5% Bond for 95 cents, who would buy it from you for 95 cents if interest rates go to 6% ???
They'll buy one for 94 cents. :oops:

Anyway, I'm sure others will chime in with better explanations. I have a Treasury Direct account, and was purchasing Treasury bills prior to the 2008 crash. Back then, they had what's called an "Inverse Yield", wherein short term rates 3,6 months etc, were higher than long term rates, but no longer.
The Auction held by the treasury comes every so often, and if you just put in an order for a Bill, note or Bond, you will get one at the offered rate.
My understanding is that there are some folks who want 1.05% instead of the 1% being offered (just a number I threw out), so, the treasury will give you yours, then start selling to others at possibly a higher interest rate....maybe.

That being said, I'd certainly go with Ally, because even the 10 year Treasury is yielding something like 2.35% or so, and 10 years is a long time indeed.
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lack_ey
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Re: Very confused by Bonds

Post by lack_ey » Mon Oct 09, 2017 10:17 pm

anonsdca wrote:
Mon Oct 09, 2017 9:55 pm
1) I read about US Treasury Bills and follow the link to TreasuryDirect and their seems to be noticeable return rates I can grasp onto and they start talking about buy "at auction"! Oh My, seems like too much. These seem to be short term (0-1 YR).

2) I read about Treasury Notes (1-10 Years) seems confusing also. Again, looks like you buy at a discount to Par, and get paid every six months or so.
The Treasury regularly issues new bonds/notes/bills. There's an auction process to determine the exact price, the mechanics of which are not that relevant for your purposes. You can very readily also buy bonds off the secondary market (i.e. from somebody else, effectively, so not a new issue when it is being offered) fairly cheaply and simply. A Treasury note can be at a premium rather than a discount—actually I think there was a brief case in the US of a Treasury bill being issued at a very slight premium to par before, so the yield was negative [edit: that was wrong, see later]—for the note it depends on the yield relative to the interest rate. A note bearing a 3% coupon but at a premium may have a yield of 2.5%, for example. That's not a big deal; yield is what counts.
anonsdca wrote:
Mon Oct 09, 2017 9:55 pm
Are there any safe Bonds, that act like a CD and return more than a CD? I have about $35K, so looks like I can get 2.25% at Ally.
Depends what you consider safe. Not a Treasury bond or something of similar credit quality and risk profile, at least compared to relatively good CDs. Ally's rates are not the absolute highest but no, you're currently not going to find top-quality 5-year bonds with rates as high as 2.25%.

In fact, a lot of the time you can get better returns for the risk from CDs rather than government and other bonds, at least to the degree that you are covered by FDIC insurance on the CD such that the risk is low.
anonsdca wrote:
Mon Oct 09, 2017 9:55 pm
Can you do anything better with Bonds? This $35K is not my EF. I have 25 months of that already at CapOne at 1.2%. I really like the idea of this Bond thing but it seems confusing. I would like something that cannot go down in value, so I think that leaves Bond funds out as they can go down?
Bond funds go down because they hold bonds, which can go down. The value of a bond fluctuates over time. If a bond* doesn't default, all its payments are known ahead of time, You know exactly how much money you're going to make and when. However, the value of those payments changes. For example, consider this: what would you pay for a government guarantee to be paid $1,000 in 10 years from today? That would depend in part on what else is available, what inflation might be, where interest rates might be headed, etc., right? So naturally that value isn't a constant.

*at least for a "regular" bond without some of the kinds of features that would make the statement not true more broadly; the statement is true for Treasury bonds/notes/bills

Direct bank CDs are not marketable, but nevertheless in some sense you could kind of "mark to market" based on how interest rates are changing and say that a CD is going down in value in a similar way. A CD is less of a good deal for you if rates actually jump up, so there's an opportunity cost if nothing else, if you want to think of it that way (though many direct CDs have early withdrawal provisions with some kind of penalty that is typically not as high as it probably should be). Brokered CDs that you can buy in a brokerage and sell actually have market prices and do go down in value.
Last edited by lack_ey on Wed Oct 11, 2017 5:36 pm, edited 1 time in total.

anonsdca
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Re: Very confused by Bonds

Post by anonsdca » Mon Oct 09, 2017 10:19 pm

Thank you Z3,

I checked out the chart on that. I could be misunderstanding it but it seems if you invested $10K 5 years ago, you have $11K now. Is is possible this same investment of $10K--now, could be worth $9K in the next 5 years? If so, this is not the kind of investment I am looking for. I would like my principal back back with interest after a certain term. Isn't that what bonds do?

anonsdca
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Re: Very confused by Bonds

Post by anonsdca » Mon Oct 09, 2017 10:30 pm

@Jerry, thanks. I haven't looked too much at Bond Funds because I figured they could go down and that is not what I want for this specific allocation. I want a sure thing.

anonsdca
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Re: Very confused by Bonds

Post by anonsdca » Mon Oct 09, 2017 10:39 pm

@lack, thanks for the information, still digesting some of it, but it seems you are suggesting a CD is the way to go here.

Questions:

Is there any real difference in a CD and Bond?
Are we just trying to get the best safest--highest yield with either?
Why not be 80/20 (or whatever your AA preference is) in stocks and CDs, rather than stocks and bonds?
Do you think with rates rising, will bond funds will have pressure the next few years? If I am not invested in them now, why do it?

Are other Governmental bonds worth looking into that the Wiki mentions? I only looked at the top 2. Any higher yields there?

US government bonds
United States Treasury security
Treasury bond

Like these?

Treasury Inflation Protected Security
GNMA
Government agency bonds
EE savings bonds
I savings bonds
Zero-coupon bond

lack_ey
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Re: Very confused by Bonds

Post by lack_ey » Mon Oct 09, 2017 11:13 pm

anonsdca wrote:
Mon Oct 09, 2017 10:39 pm
Is there any real difference in a CD and Bond?
A brokered CD that you can buy or sell is pretty much just a specific type of bond with government backing of par value via FDIC insurance (under per-person-and-institution insurance limits). A direct CD with a bank is a bit different in the sense that it is not a marketable security you can turn around and sell to anyone else. Regardless, this is all fixed income and serves a similar role from an investment point of view.
anonsdca wrote:
Mon Oct 09, 2017 10:39 pm
Are we just trying to get the best safest--highest yield with either?
Depends who "we" are. Usually safer is better, and higher yield is better. Some buy, hold, trade, etc. for different purposes. For example, somebody might want to use bonds to try to market time interest rates. There's also the possibility that bonds—especially Treasury bonds—might actually gain value when stocks are really tanking. That happens in some financial crises in which stocks get hammered, notably in 2008-2009, though it's not something reliable you can count on every time. But some hold in part hoping for that benefit.

More importantly, it's possible to take more risk in bonds for potentially a higher return (should have a higher return on average), though depending on how much extra risk, it may not be more than good CDs anyway. The extra risk may have some undesirable properties. Others might find the trade-off acceptable.

Some just don't have the time or compulsion to try to optimize and hunt for a somewhat better deal and just want the convenience of funds for all their fixed income. For example it's probably not worth hunting around and managing CDs for an additional $50 a year for some people.
anonsdca wrote:
Mon Oct 09, 2017 10:39 pm
Why not be 80/20 (or whatever your AA preference is) in stocks and CDs, rather than stocks and bonds?
With a brokered CD, bid/ask spreads are relatively high so selling to rebalance or other portfolio maintenance can be less convenient. For brokered CDs and also a lot of direct CDs, it may not be easy or convenient to do a partial liquidation or add incremental funds regularly.

And also see everything else written above.
anonsdca wrote:
Mon Oct 09, 2017 10:39 pm
Do you think with rates rising, will bond funds will have pressure the next few years? If I am not invested in them now, why do it?
Depends how fast rates rise. The market actually doesn't expect much movement in Fed funds rate among other things, so if you're expecting rates to be significantly higher in the near term, then that's not priced in and you would use this tactical view to market time away from the bonds you think might be on their way down. Yields across the yield curve could readily go down if conditions change, or perhaps rise slower than expected.
anonsdca wrote:
Mon Oct 09, 2017 10:39 pm
Are other Governmental bonds worth looking into that the Wiki mentions? I only looked at the top 2. Any higher yields there?

US government bonds
United States Treasury security
Treasury bond

Like these?

Treasury Inflation Protected Security
GNMA
Government agency bonds
EE savings bonds
I savings bonds
Zero-coupon bond
The TIPS should have similar return as a regular Treasury bond of similar maturity, though it depends on how inflation does, and the exact pricing of the time. They have a lower yield but the principal adjusts with inflation. So if inflation turns out higher than expected, they can earn more than nominal Treasuries (the reverse can also happen).

GNMAs have higher yields but in exchange for a different return distribution and properties. You could think of it as additional risks being priced in. These are pass-through securities for underlying mortgages, where you receive principal and interest from those mortgages, wrapped around with a government guarantee for those payments. There's no free lunch and it's not even that much additional yield.

Government agency bonds are not issued by the Treasury and aren't guaranteed by the government, but are from the kinds of government-sponsored agencies that nobody really expects to default. There's some additional return here. Some consider some mortgage-backed securities from Freddie or Fannie (rather than Ginnie Mae like for GNMAs) in this category. You get lower liquidity than Treasuries and slightly more risk for a little higher yields.

EE savings bonds are non-marketable securities with a very low yield. Except for that fact that if you hold for 20 years, you get an immediate doubling of the original value (so effectively a return of 3.53% annualized over 20 years). You're limited to $10k per person a year. You can withdraw earlier than that after the 1-year mark, but it's probably not worth it if it's getting on in years.

I savings bonds are non-marketable securities also with the $10k limit. You can also withdraw as early as 1 year, and it might make sense at times. It can go up to 30 years. The return is pretty low, though, but it tracks with inflation. The current yield being given is zero above inflation, but it's been higher in the past. Currently you'll likely get a higher return from TIPS, though TIPS carry interest rate risk.

A zero-coupon bond is a bond without any interest (coupon) payments, just the principal returned in the end. So usually they just trade at a discount to end up with similar yields as other bonds. There's not any additional yield here.

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CaliJim
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Re: Very confused by Bonds

Post by CaliJim » Tue Oct 10, 2017 12:01 am

Many thoughts here:

CD's do seem to be a better deal at the moment.

If you buy a bond or note when issued from treasury direct, and hold it until maturity, you will collect all your coupons, and get all your principle back. But everywhere and always there is risk. Thinking "I'll get all my principal back" ignores inflation risk and takes a view of things that is too conservative for my taste. But many wise and frugal people have bought individual gov't bonds and done OK. Many roads to Dublin.

For myself, I love the simplicity of the Vanguard Total Bond Fund (and CA Muni Fund in taxable). The price fluctuates a bit, but over the years it has outperformed CD's. And if the terms and conditions of specific bonds are confusing, and treasury direct is daunting to you, leave the details to the trustworthy experts at Vanguard and buy the the Vanguard Total Bond Market Index fund or ETF.

IMHO, CD's and bonds are a perfect vehicle for saving for a specific short term (2 to 10 year) goal. But a mixture of a bond fund and a stock index fund is a much better vehicle for retirement savings. And historically this has been true: portfolios with a mixture of stocks and bonds have done better that bonds alone over most, if not all, ten year periods.

To my thinking, a retirement portfolio of mostly Gov't Bonds may be 'safe' in the sense that you get your money back, but at the same time, you are leaving money on the table, and they may not be safe in the sense that you earn so little that your retirement account will be insufficiently funded!

In other words, a low risk investing plan may be safe, but what good is it if it fails to even get close to it's goal. A little risk can be a good thing. And the difference between 2% return and 5% return, compounded over 20 or 30 years is HUGE. Compound interest is AMAZING!

Is this chunk of money that you want to put into bonds something that you are saving for specific future goal (ie. new car purchase, college fund, etc) or is it part of your general retirement savings?
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Re: Very confused by Bonds

Post by anonsdca » Tue Oct 10, 2017 12:13 am

@CaliJim, thank you for your response.

It's a good point about inflation risk. Admittedly, I have not give that much thought--I will do so, but even you seem to be suggesting CDs are best at the moment for my purpose.

You are correct. I am triangulating on a short time (3-5 years). This is for retirement, but it's a bridge from early retirement to SS and taking IRA/401k funds.

You mention a "little risk is a good thing"--I totally agree. However, I already have a LOT of risk (not a little) in my equity position of the portfolio. I am ok with that risk. After all, after my EF, I am 100% equity. I am looking to add a safe % of AA now.

For this allocation of money (AA), I am exploring a safe return. I would like nice income (if possible/ CD or more) and a safe return of my money. Is that possible?

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Re: Very confused by Bonds

Post by venkman » Tue Oct 10, 2017 2:24 am

anonsdca wrote:
Tue Oct 10, 2017 12:13 am
You mention a "little risk is a good thing"--I totally agree. However, I already have a LOT of risk (not a little) in my equity position of the portfolio. I am ok with that risk. After all, after my EF, I am 100% equity. I am looking to add a safe % of AA now.

For this allocation of money (AA), I am exploring a safe return. I would like nice income (if possible/ CD or more) and a safe return of my money. Is that possible?
Risk and return are ALWAYS related. If you want an investment that is completely safe, it will have a low return. If you want anything higher than that, you necessarily have to take some risk.

I think CD's would be perfectly fine for your situation, given that you are otherwise 100% in equities. (CD's tend to have a slightly higher yield than Treasuries because big-money investors (corporations, etc.) generally buy Treasuries and not CD's.) The general feeling around here is that you take risks with the equity part of your portfolio, and keep the bond side in mostly safe investments. Don't worry about getting a higher return; you'd have to take on a LOT more risk to get a yield significantly higher than a CD right now.

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Re: Very confused by Bonds

Post by CaliJim » Tue Oct 10, 2017 12:48 pm

anonsdca wrote:
Tue Oct 10, 2017 12:13 am
@CaliJim, thank you for your response.

It's a good point about inflation risk. Admittedly, I have not give that much thought--I will do so, but even you seem to be suggesting CDs are best at the moment for my purpose.

You are correct. I am triangulating on a short time (3-5 years). This is for retirement, but it's a bridge from early retirement to SS and taking IRA/401k funds.

You mention a "little risk is a good thing"--I totally agree. However, I already have a LOT of risk (not a little) in my equity position of the portfolio. I am ok with that risk. After all, after my EF, I am 100% equity. I am looking to add a safe % of AA now.

For this allocation of money (AA), I am exploring a safe return. I would like nice income (if possible/ CD or more) and a safe return of my money. Is that possible?
I would not worry about unexpected inflation risk over a 3-5 year horizon. Wages are stagnant and in my cloudy crystal ball I don't see that changing soon.

You do have a lot of risk! Is your equity diversified (more than 100 individual company stocks, ie: total us market index or total world index?)

I don't like 100% equity AT ALL (excluding EF and bridge fund) when you are this close to retirement. You might not be able to afford a 50% market decline followed by a Japanese style 30 year recovery. 25% to 50% of your retirement portfolio in a good diversified bond fund is your friend.

We would ALL like good safe income with little risk!

As mentioned, risk and return are ALWAYS related in our information age of somewhat, often mostly, efficient markets.

(I know a value investor who thinks CD's and Bonds are riskiest, as in, most likely to underperform other investments, over long periods of time. But then he is a multi-multi-millionare who lives in a different world than you and me.)
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CaliJim
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Re: Very confused by Bonds

Post by CaliJim » Wed Oct 11, 2017 11:58 am

OP,

The Alan Roth article mentioned in this post is somewhat relevant.

viewtopic.php?p=3568320#p3568320
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visualguy
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Re: Very confused by Bonds

Post by visualguy » Wed Oct 11, 2017 12:44 pm

CaliJim wrote:
Wed Oct 11, 2017 11:58 am
OP,

The Alan Roth article mentioned in this post is somewhat relevant.

viewtopic.php?p=3568320#p3568320
Even from that article, it's not clear why you would pick a bond index fund (such as BND) vs CDs. If interest rates go up or something else happens that hurts bond funds, you would be better off in CDs. If nothing happens, you don't lose anything by being in CDs because bond funds like BND don't return more.

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Re: Very confused by Bonds

Post by Valuethinker » Wed Oct 11, 2017 3:58 pm

anonsdca wrote:
Tue Oct 10, 2017 12:13 am
@CaliJim, thank you for your response.

It's a good point about inflation risk. Admittedly, I have not give that much thought--I will do so, but even you seem to be suggesting CDs are best at the moment for my purpose.

You are correct. I am triangulating on a short time (3-5 years). This is for retirement, but it's a bridge from early retirement to SS and taking IRA/401k funds.

You mention a "little risk is a good thing"--I totally agree. However, I already have a LOT of risk (not a little) in my equity position of the portfolio. I am ok with that risk. After all, after my EF, I am 100% equity. I am looking to add a safe % of AA now.

For this allocation of money (AA), I am exploring a safe return. I would like nice income (if possible/ CD or more) and a safe return of my money. Is that possible?
3 to 5 years?

The simplest and lowest risk thing to do is buy CDs, stay within FDIC limits for each institution (that is really important) and not worry about it. Your money will be safe).

Treasury Direct requires more sophisticated knowledge. Bond funds expose you to volatility.

Simple beats complexity. Complexity is the enemy of a good plan.

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Phineas J. Whoopee
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Re: Very confused by Bonds

Post by Phineas J. Whoopee » Wed Oct 11, 2017 4:23 pm

Jerry55 wrote:
Mon Oct 09, 2017 10:14 pm
...
My understanding is that there are some folks who want 1.05% instead of the 1% being offered (just a number I threw out), so, the treasury will give you yours, then start selling to others at possibly a higher interest rate....maybe.
...
I'm afraid that's a misunderstanding. The US Treasury does not set yields on its marketable securities. They are determined strictly by auction, and everybody who wins the auction gets the same yield.

There's one confusing point: the Federal Reserve conducts the auctions on behalf of the Treasury, but does not borrow or lend the money itself. The auction is simply one of the banking services the Fed provides to the US federal government. (The Fed donates all its profits to the Treasury. What else would they do with them?)

Here's the process:

The Treasury decides it will borrow some money, a set amount, using some instrument. Let's imagine the amount is $10,000,000,000 (ten billion dollars), using the two-year note. It informs its banker, the Fed, of the fact. That's the end of Treasury's involvement.

The Fed publicly announces a sealed-bid auction and solicits bids. Anybody who wants to can view the announcement.

There are two types of bidders: competitive; and noncompetitive.

Competitive bidders submit sealed bids, that is nobody knows what anybody else's bids are. They're in the form of: I'll take one billion of that offer if I can get an annualized yield of at least 1.4%.

Noncompetitive bidders (who are usually interested in smaller amounts) say: I'll take ten thousand of that offer, and I'll accept whatever the outcome of the auction is.

Shortly after the bidding deadline the Fed opens all the bids, arranges them in order from lowest requested yield to highest, and starts accepting them. First it accepts all the noncompetitive bids. Then it accepts competitive bids, from lowest to highest, until the full ten billion dollars is filled. Every successful bidder gets the yield from the highest accepted bid.

A couple of days later a settlement process takes place, cash passes into the Treasury's checking account, and the securities are issued to the successful bidders.

The reason I went into so much detail is it's a common misunderstanding that the government sets the yields, and that the Fed is the one being transacted with. Neither is true.

Hope this was helpful to somebody out there.

PJW
Last edited by Phineas J. Whoopee on Wed Oct 11, 2017 9:58 pm, edited 1 time in total.

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Re: Very confused by Bonds

Post by Phineas J. Whoopee » Wed Oct 11, 2017 4:24 pm

lack_ey wrote:
Mon Oct 09, 2017 10:17 pm
...
The Treasury regularly issues new bonds/notes/bills. There's an auction process to determine the exact price, the mechanics of which are not that relevant for your purposes. You can very readily also buy bonds off the secondary market (i.e. from somebody else, effectively, so not a new issue when it is being offered) fairly cheaply and simply. A Treasury note can be at a premium rather than a discount—actually I think there was a brief case in the US of a Treasury bill being issued at a very slight premium to par before, so the yield was negative—for the note it depends on the yield relative to the interest rate. A note bearing a 3% coupon but at a premium may have a yield of 2.5%, for example. That's not a big deal; yield is what counts.
...
If I may, at present there is no mechanism by which to bid a negative nominal yield for US Treasury securities. There was a period of time when 3-month bills were trading at a slightly negative yield, but they weren't issued with one.

What both can and does happen is coupons are multiples of 0.125%, one eighth of a percent. In order to dial in the exact yield requested by the highest successful bidder the price, not the face value but the price, is adjusted.

There is a mechanism by which to bid a negative real yield for TIPS.

PJW

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Re: Very confused by Bonds

Post by lack_ey » Wed Oct 11, 2017 5:35 pm

Phineas J. Whoopee wrote:
Wed Oct 11, 2017 4:24 pm
lack_ey wrote:
Mon Oct 09, 2017 10:17 pm
...
The Treasury regularly issues new bonds/notes/bills. There's an auction process to determine the exact price, the mechanics of which are not that relevant for your purposes. You can very readily also buy bonds off the secondary market (i.e. from somebody else, effectively, so not a new issue when it is being offered) fairly cheaply and simply. A Treasury note can be at a premium rather than a discount—actually I think there was a brief case in the US of a Treasury bill being issued at a very slight premium to par before, so the yield was negative—for the note it depends on the yield relative to the interest rate. A note bearing a 3% coupon but at a premium may have a yield of 2.5%, for example. That's not a big deal; yield is what counts.
...
If I may, at present there is no mechanism by which to bid a negative nominal yield for US Treasury securities. There was a period of time when 3-month bills were trading at a slightly negative yield, but they weren't issued with one.

What both can and does happen is coupons are multiples of 0.125%, one eighth of a percent. In order to dial in the exact yield requested by the highest successful bidder the price, not the face value but the price, is adjusted.

There is a mechanism by which to bid a negative real yield for TIPS.

PJW
Never mind, you're right. I thought it was that they allowed it at auction for bills and that happened, but no, it was just 0% and then trading negative by the next day (in addition to going negative at some other times as well).

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Re: Very confused by Bonds

Post by SimplicityNow » Thu Oct 12, 2017 11:11 am

I'd recommend Annette Thau's "The Bond Book" for a good read.

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