If Treasuries Were Downgraded, Why Did Rates Fall?

Jim Lorenzen, CFP®, AIF®

It IS confusing, isn’t it?  The `downgrade’  was supposed to result in higher rates on Treasuries, which would depress the bond markets!   Some people thought it would affect all borrowing!

But, what happened isn’t that difficult to understand; and, in fact, was easy to foresee, as many bond traders apparently did.

But first, a little quick overview of how bonds trade might be in order:

Bonds are issued with a face value and a coupon.  The face value, for example, might be $10,000.  Let’s say our hypothetical bond pays a coupon of $200 annually.   That means if our bond was purchased at face value, the annual coupon payment would actually be a 2% yield.  T he coupon payment doesn’t change; but the calculations can produce different yields, based on market trading.   For our little example, I’ll be talking about current yields only – the yield realized based on the purchase price of the bond.  We’ll ignore yield-to-maturity, yield-to-calls, and tax issues for the purpose of this hypothetical.

In the marketplace, bonds seldom trade at face value.   They generally trade either at a premium or a discount, based on market forces – it’s basic supply and demand.   

When demand is high, the price goes up, just like for anything else!    So if there’s a huge demand for our type of bond – let’s say it has a 3-year maturity that is considered safe – the price of the bond will likely go up!   So what happens to the yield if the price increases?

Let’s say our bond was originally purchased for $8,000 and was therefore yielding 2.5% (the $200 coupon represents 2.5% of the purchase price).    If demand is high, our hypothetical bond seller might be able to get $9,000 for it, which means our buyer would have a bond that will have a current yield of 2.2%, since that $200 coupon represents an annual return of 2.2% on a $9,000 investment!    The price rose due to market forces, high demand, and the yield decreased as a percentage of the price, because the coupon remained the same.

Likewise, if demand was down and the price had been reduced to, say $7,000, the buyer’s current yield would be 2.9%.  So, as bonds trade up or down, yields move inversely down or up.

Okay.   Let’s go back to the downgrade.  When everyone expected rates to go up, why did they go down in the bond market?  Demand!

When the downgrade hit, my guess is that most investors knew the Government’s ability to pay creditors was, in fact, not in jeopardy.  Current revenue was more than sufficient to pay all outstanding debt obligations; so, that I don’t believe was an issue.  Here’s what I believed happened:

• Stock market investors – mostly institutions that make large investments in American and global businesses on behalf of smaller investors – passed judgment on Congress’ ability to deal with our national debt.  The feeling was likely that the huge $14 trillion debt, combined with what’s already happened (looming increased health care costs, increased regulatory compliance costs, and an uncertain outlook for future taxes), produced a `no-confidence’ vote on Wall Street.
• The stock sell-off produced sale proceeds that had to be invested somewhere.  There are no `coffee cans’ in the closets of these institutions.   There aren’t many choices:  Cash and short-term paper (money market and T-bills, for example).   This increased demand in the bond markets caused bond prices to increase;  and, as we’ve seen in our hypothetical bond example, when prices go up, the bond coupons represent a smaller percentage of the bond values being traded, so yields come down.

This market dynamic may or may not affect bank borrowing or mortgage loan rates, which also have their own demand-supply dynamics; but, it might explain what happened in the bond markets, and why.
 

Jim

 

NOTE:  Jim Lorenzen was interviewed by The Wall Street Journal’s Glenn Ruffenach for an article appearing in SmartMoney magazine.  You’ll find it on page 46 in the September 2011 issue now on newstands.

Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER™ and an Accredited Investment Fiduciary^®  in his 20th year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California.   IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description.  Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader.  The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.