Friday, December 26, 2008

Bond Basics

All blog entries at Rotten Investments are subject to our DISCLAIMER.

Mention Treasury bonds to most people and they'll think of the EE savings bonds that you see people buy for newborns or for children for their birthdays and other special occasions. EE savings bonds are issued at a discount to face value and earn a fixed rate of return for the life of the bond.

The 30 Year Treasury bond bears little similarity to a savings bond, except for the Federal government-backed guarantee. The 30 Year Treasury bond gets issued with a fixed coupon, with interest paid in two installments each year, but can not be redeemed prior to its maturity date. Only at maturity does the investor receive the face value of the bond.

While 30 Year Treasury bonds are not redeemable, they are transferrable. There is a dealer market for bonds and investors can buy and sell bonds (and notes) of almost any length of duration. If you have an online discount brokerage account, you should be able to view a menu of offerings available for purchase. If you own Treasuries, your discount broker should be able to get you an offer for any bonds you wish to sell.

The value of the EE savings bond is known at any given time by the tables maintained by the Treasury department for anyone wishing to redeem their savings bonds. The value of the 30 Year Treasury bond, or any other Treasury bond or note, is driven solely by market forces. With the interest rate fixed upon issuance, the bond itself becomes more valuable or less valuable depending upon what interest rates are doing in the market-place. As market interest rates rise, the value of a fixed interest rate security falls. And as market interest rates decline, the value of the same security will increase.

Herein lies the risk, and potential reward, of investing in bonds. The 30 Year Treasury Bond that was issued back in May with a coupon of 4.5% is now worth nearly 140. (The Treasury strives to match coupon rates to the market so that bonds are prices near par... or 100... upon issuance.)

So a Treasury bond investor who bought the 30 Year Treasury bond back in May is currently sitting on a gain of nearly 40%. That's an awesome total return for a Treasury bond. Unfortunately, that kind of a return is attracting investors to Treasuries who don't understand the risks of buying and holding longer-term fixed-income securities. Because when rates do go back up again, and they will, Treasury bonds are going to get hammered.

Taking a short position against Treasuries is not without risk. There are a number of ways you can play this trade. You can short the 30 Year Treasury bond futures. You can buy puts (or short calls) on certain Treasury Bond ETF's. Options trade on the iShares Lehman 20+ Year Treasury Bond (root symbol: TLT). There are interest rate options that trade on the yield of the 30 Year Treasury Bond (root symbol: TYX). All of these possibilities have their own risk/reward profile. It's up to you how to take this position, should you decide to play along.

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