The Inverse Relationship

It's hard to believe that after four years of business school and ten years of practical experience, the meaning of bond inverse relationship finally dawned on me.  I was in my mid thirties.  Hopefully, you will not have the comprehension problem that plagued me and will quickly grasp the reasoning behind the "inverse relationship" of fixed assets; i.e., bonds, treasuries and bond funds.   As golf is a game of opposites, so it may be said of bonds.  We mistakenly think, as purveyed by some financial advisors, that our principal or equity is much safer in bonds as compared to other assets.  Perhaps that's true, but you damn well better understand what you're getting involved with before making that commitment.  Let me explain.

If you purchase a $1,000.00 ten-year treasury that is yielding 4%  you'd think the risk of principal erosion is minimal, or non-existent while you hold the bond.  The reality is quite the opposite, or inverse, depending on the current marketplace yields. 

For instance, if yields went up to  5% in the first year you owned the bond and you needed to cash it in, the equity or principal would most likely be 20% less than your $1,000.00 investment, or $800.00.   This is because the new investor (or buyer) doesn't want  to pay face value ($1,000.00) for a bond earning 4% when they can  purchase a $1,000.00 bond for today's 5% yield.  However, they will pay the lesser amount of $800.00 at 4% yield because if they own it for the full ten year maturity period, they will recoup the actual face value of  $1,000.00. The amplitude of the inversion increases with the length of the holding period.  If the holding period is short, then yield variations will not have such a great impact.

Does this clear up the meaning of inverse relationship as it relates to bond purchases?  Please feel free to question me if it does not.

Now, why am I writing  this?  Because many of you will be making investment decisions over the coming years and understanding these principles, and also some serious no-nos, are important.  Serious no-no number one is  NEVER, I mean NEVER invest in a mutual bond fund.  Mutual bond funds are relegated by their prospectus which outlines management's intentions (the word bias is commonly used), limitations and structure among other things.  Many managers have to trade bonds well before their maturation dates, forcing losses and tax consequences which would be avoided if you held the instrument directly.  If you held a bond directly and the yields move unfavorably, no principal would be lost if you held to maturity.

Most bond funds don't have that luxury because they have to liquidate when holders ask for cash back.  When interest rates start rising, people liquidate and reallocate their assets which negatively affects the principal or equity of  investment shares.  So please, there will be times and places for fixed asset allocation such as bonds, but none should be in the land of mutual bond funds.

I''ll be back soon.

(Reminder:  Check this blog's archives for other artcles.)

Steve M