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 wiggles
One Winged Angel
 
Registered: 11/09/05
Posts: 2,387
Last seen: 1 month, 9 days
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 How can bonds and stocks both be doing poorly?
#8140949 - 03/13/08 11:02 AM (6 months, 22 days ago) |
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It is my impression that usually when stocks are down, bonds usually go up - thats because bonds basically equate to debt.
So, is there a reason why most of my bonds/bond funds are going down right now, alongside my stocks? I thought I was better diversified  I'd say its just a temporary thing but its been a gradual decline for close to 6 months now.
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You can turn your back on a person, but never turn your back on a drug, especially when its waving a razor sharp hunting knife in your eye.
Hunter S. Thompson
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phi1618
old hand
Registered: 02/14/04
Posts: 3,722
Last seen: 10 hours, 35 minutes
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Re: How can bonds and stocks both be doing poorly? [Re: wiggles]
#8141057 - 03/13/08 11:24 AM (6 months, 22 days ago) |
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First, some background information:
Bonds are tradable debt. They have principle, interest rates, and maturity. If the issuer remains solvent until maturity, they will be payed of in a single payment on maturity. If the issuer goes bankrupt, bonds are more senior (get payed before) equity (stock holders) but after secured loans. There can be various debt issuances with various seniority, but this is a general view of what a bond is.
Bonds have two major risk components: interest rate risk and credit risk.
Interest rate risk is the risk that future rates will be higher, which will decrease the current value of the future payment represented by a bond. For example, let's say you buy a $1000 2 year treasury note today paying an annual interest rate of 1.5%. What is the note worth tomorrow if two year treasury rates rise to 2.0%? Answer: roughly $990. The reason for this is that a $1000 bond bought today will have a larger payout than the one you bought yesterday.
Credit risk is the risk that the issuer will default - obviously, treasuries pay lower rates than Big Stable Inc. bonds which in turn pay lower rates than Fly By Night Inc. bonds to compensate the holder for the risk that the issuer will be unable to pay.
What's happened now is that large leveraged institutions (including banks) have taken large losses and need to reduce their exposure to risk asap. As a result, demand for safe assets like treasuries has risen (and the interest rates no short term treasury debt are currently negative after accounting for expected inflation) and demand for less safe assets like corporate debt has fallen, resulting in lower prices and higher interest rates.
Usually, the price of bonds will move inversely with interest rates - as the FED lowers rates to help the economy, bond prices rise. Right now, bond prices are falling even though the FED funds rate is falling because interest rates on debt with a distant maturity or significant credit risk are rising.
As a matter fact, credit markets (though they've recovered a tiny bit in the last couple days) are projecting a giant spike in defaults based on the premium for more risky debt - though as I explained above, I believe that prices are driven more by technical factors (banks unloading risk) than fundamental factors (we're about to enter one momma of a recession).
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 Veritas
Registered: 04/15/05
Posts: 9,721
Loc: PNW
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Re: How can bonds and stocks both be doing poorly? [Re: phi1618]
#8141236 - 03/13/08 12:09 PM (6 months, 22 days ago) |
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Great response! 
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