Can someone explain corporate bonds & inverse yield curves to me?

[Pliablemoose]

I bought some Merril Lynch corporate bonds the other day & I have no freaking idea what the hell an inverse yield curve is.

Anyone have a simple explanation they can use with sock puppets so I can understand them?

 

[darthsidious]

Simple explanation : an inverted yield curve is a phenomenon where interest rates in the short term are higher than for the long term. Usually, we are used to expecting higher rate of return the longer we invest our money in something like a CD. In normal circumstances a 1 year CD will give 5%, and a 5 year CD might give 5.5% (I made the numbers up; all thats important is the increasing trend). With an inverted yield curve,a 1 year CD might pay 5% interest, while a 5 year CD might only pay 4.5%. This happens because the market believes that rates will drop in the near future, and noone wants to lend money long term at the current higher rate. It's also supposed to be a somewhat reliable indicator of a impeding rescession (though this is contended back and forth).

<-- I'm an EE, and I've never taken any classes etc. to do with finance, so don't fully trust anything I say.

 

[lupi]

Inverted Curve
Date: August 1981
At first glance an inverted yield curve seems like a paradox. Why would long-term investors settle for lower yields while short-term investors take so much less risk?

The answer is that long-term investors will settle for lower yields now if they think rates ? and the economy ? are going even lower in the future. They're betting that this is their last chance to lock in rates before the bottom falls out.

Our example comes from August 1981. Earlier that year, Federal Reserve Chairman Paul Volcker had begun to lower the federal funds rate to forestall a slowing economy. Recession fears convinced bond traders that this was their last chance to lock in 10% yields for the next few years.

As is usually the case, the collective market instinct was right. Check out the GDP chart above; it aptly demonstrates just how bad things got in 1981 and 1982. Interest rates fell dramatically for the next five years. Thirty year bond yields went from 14% to 7% while short-term rates, starting much higher at 15% fell to 5% or 6%. As for equities, the next year was brutal (see chart below). Long-term investors who bought at 10% definitely had the last laugh.

Inverted yield curves are rare. Never ignore them. They are always followed by economic slowdown ? or outright recession ? as well as lower interest rates across the board.

 

[WildHorse]

Well the interest rate is the price lenders charge you to borrow money.

1 / bond price = interest rate for that bond.

There?s a ?term structure? for interest rates that is graphed as a yield curve line describing short & long term I rates. The Fed sets the short tern I rate. Expectations of investors in the market (i.e., psychology) sets the long term I rate.

A steep positive sloped yield curve is typical of the start of a phase of economic boom. This indicates increased demand for capital by producers to expand their production, leading eventually toward inflation. This is the time to buy stock.

When the yield curve line goes flat, slope=0, it indicates the economic growth spurt is slowing down, maybe but not for certain a recession is coming.

When the yield curve line goes negative slope or, "INVERRTED" (this is when the short term I rate > long term I rate) it?s a very strong signal the stock market will tank, a recession is coming. Then investors sell out of their stock positions and the money flows into bonds instead.

So there?s a thumbnail sketch.

 

[LegendKiller]

Originally posted by: scott
Well the interest rate is the price lenders charge you to borrow money.

1 / bond price = interest rate for that bond. bond price equals anything stated as 1.0 or below.

There?s a ?term structure? for interest rates that is graphed as a yield curve line describing short & long term I rates. The Fed sets the short tern I rate. Expectations of investors in the market (i.e., psychology) sets the long term I rate.

A steep positive sloped yield curve is typical of the start of a phase of economic boom. This indicates increased demand for capital by producers to expand their production, leading eventually toward inflation. This is the time to buy stock.

When the yield curve line goes flat, slope=0, it indicates the economic growth spurt is slowing down, maybe but not for certain a recession is coming.

When the yield curve line goes negative slope or, "INVERRTED" (this is when the short term I rate > long term I rate) it?s a very strong signal the stock market will tank, a recession is coming. Then investors sell out of their stock positions and the money flows into bonds instead.

So there?s a thumbnail sketch.

Your 1/p only applies to bonds trading at a discount to par. This can be the case if it's a discounted bond, or if the bond's interest rate is less than current interest rates. A bond with an interest rate = to market = par bond, so yours would yield nothing even if it's actual yield was 4.5%.

As other have explained, an inverted yield curve is where short-term borrowing is more expensive than long-term borrowing. This happens when people's expectations are that long-term interest rates will be lower than short-term interest rates.

 

[Pliablemoose]

So my "medium Term NT S 9% 6/29/2022" Will pay 9% quarterly and mature in 22'?

 

[LegendKiller]

Originally posted by: lupi

Inverted yield curves are rare. Never ignore them. They are always followed by economic slowdown ? or outright recession ? as well as lower interest rates across the board.

Inverted curves aren't perfectly correlated to an economic downturn. We had an inverted curve in the last year, but now it has become a normal curve.

The common misconception here is that when the economy takes a dive, the Fed cuts rates. Thus, if people perceive an economic downturn they expect rates to lower, causing an inversion. This is mainly due to the idea that the Fed sets rates based solely upon economic health. However, the main driver behind rate changes has been currency protection, inflation fighting.

Inflation usually ticks up when an economy is at it's peak, rates are raised to cool the economy. If inflation is low but people think the economy isn't strong enough, they expect the Fed to lower rates, as they did last year. Now, inflation is ticking up and the economy is still strong, they expect rates to raise or to stay the same (then you get preferred environment or compensation for deferred compensation driving higher later-term rates).

There's a lot more to this than just a simple correlation.

 

[LegendKiller]

Originally posted by: Pliablemoose
So my "medium Term NT S 9% 6/29/2022" Will pay 9% quarterly and mature in 22'?

Without looking at the note or particulars, it'll pay 9% annual yield (so 1/4 of 9% quarterly) and it will mature in 2022.

 

[lupi]

Originally posted by: LegendKiller

Originally posted by: lupi

Inverted yield curves are rare. Never ignore them. They are always followed by economic slowdown ? or outright recession ? as well as lower interest rates across the board.

Inverted curves aren't perfectly correlated to an economic downturn. We had an inverted curve in the last year, but now it has become a normal curve.

The common misconception here is that when the economy takes a dive, the Fed cuts rates. Thus, if people perceive an economic downturn they expect rates to lower, causing an inversion. This is mainly due to the idea that the Fed sets rates based solely upon economic health. However, the main driver behind rate changes has been currency protection, inflation fighting.

Inflation usually ticks up when an economy is at it's peak, rates are raised to cool the economy. If inflation is low but people think the economy isn't strong enough, they expect the Fed to lower rates, as they did last year. Now, inflation is ticking up and the economy is still strong, they expect rates to raise or to stay the same (then you get preferred environment or compensation for deferred compensation driving higher later-term rates).

There's a lot more to this than just a simple correlation.

I've heard the curves discussed so know the principles behind them, but I just googled and clipped the first one I found that seemed easily digestable. Don't think I actually came up with those numbers

 

[Pliablemoose]

Originally posted by: LegendKiller

Originally posted by: Pliablemoose
So my "medium Term NT S 9% 6/29/2022" Will pay 9% quarterly and mature in 22'?

Without looking at the note or particulars, it'll pay 9% annual yield (so 1/4 of 9% quarterly) and it will mature in 2022.

Well, yep, i not so good with the numbers & stuff

I did set up my first conditional bracketed sell order today though

Now if those profit taking bastards would leave TMX alone for a few days :frown: