Question about Bonds?

Ok, so I was wondering the following about Bonds.

1.) Suppose the U.S. Gov't issues US Bonds with a Face Value of 10,000. The interest rate in the economy is currently 4% and the bonds are redeemable in 30 years. As such, the bonds are currently worth 10,000/1.04^30 or 3083.187 dollars, right? (I am, for simplicity, assuming that there are no coupon payments on the bonds).

2.) Now, suppose China comes out tomorrow and decides to sell all of the U.S. Savings bonds it has bought from the U.S.. Simple Supply and Demand would tell us that an excess supply would cause the price to drop, right? However, where would present value fit into this? Would the excess supply of bonds prices to drop below their calculated current "Present Value" and thus cause them to sell at Discount? Also, how would an excess supply of bonds change the interest rate in the economy? I am assuming the U.S. gov't doesn't step in to change the money supply or buy back the bonds at a cheaper price.

Update:

Going off what Big Zack said, excess supply would drive the price of the bonds down (even lower than what the were issued at or the new time-adjusted Present Value)? As such, the yield would increase, because of excess supply? What equation describes by how much the price of the bond will change in comparison to it's pre-market event price? I.E. what relationship exists between excess supply and the % change in bond price?

Update 2:

Thanks Big Zack,

One final thing though, an excess supply of bonds would impact the price, right? I.E. we can apply the principles of supply and demand to Bonds and say that if the supply or demand curves change, then the price of the bonds will be affected?

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  • 1 decade ago
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    Saying all else equal, China is just dumping bonds.

    Looking at the after-market bond exchanges. That's where the real change in value would happen, initially. The after market cost of the bond would drop significantly. That would push the yield higher. They are issued a par 100 with a 5% coupon for simple math, 2 coupon payments a year of $2.50 per $100 in bonds. The par comes down to 80 that bond still pays that exact same coupon. Now your getting $5 in coupon payments for an $80 bond. The new yield is 6.25%.

    Now when the government goes to issue new bonds, they would have to be pretty close to the market yield. If I can buy a 29 ytm bond with 6.25%. Why would I buy a 5% yield bond with the full 30 ytm?

    If your buying these bonds with the intention of holding them to expiration you get the face value back. You could come in after China dumped all of its bonds, buy them for 80, hold them, collect the coupon then cash out for 100.

    The money supply and things like that, typically do not have a big impact on long term bond rates. That's more your O/N, 1, 3, 6 month type stuff. Hope that helped. Difficult to explain question feel free to email me if you are more confused than you were before.

    Additional response: If your going a little further in to it. You can go to treasurydirect.gov. They have a lot of links that really break down the maturities, total outstanding, new supply, etc.

    I don't know that your going to be able to pull up "China's Bond Holdings" exactly. There should a total of Indirect ownership, that represents foreign holdings. China owns about $730B last check, don't quote me on that number. Not counting the intragovernmental holdings like SS, Medicare, Va holdings, DoD, etc. There are about $7.5T in outstanding bonds. So, China theoretically holds about 10% of all outstanding US Bonds. I don't know that you can really gauge the markets appetite for for that type of excess supply. There could be some bond funds that like China being out of the equation and some that don't like it. If the stock market is down you get a little "flight to safety" in the form of bond purchasing.

    Then at the same time inflation expectations might increase, the bid-to-cover on the auctions might be down. I guess I'm saying I would personally stay on the sideline, have some cash ready to deploy. If the bond market takes a turn down in price, up in yield, in some type of knee jerk fashion like a 25BP in a day, then I'd jump in.

    If you into fixed income some really high quality firms are issueing some A and AA paper with 5, 6, 7% coupons. I think some of the firms are at that lower tier because the rating agencies are affraid to make anything AAA anymore, like the MBS, CMBS, ABS, CDO, etc...

    I'm not a bond trader or financial advisor. I have a personal interest in monetary policy, government and debt management. So I do a lot of research, more on the academic side.

    This is a commercial link, but it might answer some further questions...

    https://www.franklintempleton.com/retail/jsp_cm/sa...

    And investopedia's takes a shot at it...

    http://www.investopedia.com/articles/03/122203.asp

    As an after market play there would some immediate impact. on the face value or purchase price. So if you did believe that China was going to dump all of it's bonds and you were buying bonds in front of that you would lose money on the initial investment. I don't know if you can short bonds or not, but you would want to short bonds ahead of that. That would be borrowing bonds from a large institution, selling them at the market price now which has been pretty close to par. You borrow one bond at $100 you sell it, China dumps the bonds, the market value is now $90 then you buy it back and replace the borrowed bond with that same bond.

    Again, there are a lot of factors that affect the market. Your really looking at real interest rate, on a very generic measure is the 52-week yeild + projected inflation. New recession concerns flatten the yield curve by increasing face value of the long end bonds.

    A final final note. Looking at the stock market comared to the bond to the bond market. When the stock market is up bond traders are selling bonds and chasing a higher return in the market, there is your excess supply, lower face value, higher yield. The stock market turns lower, people shift to capital preservation mode and safety, increasing the demand for a safe haven like US bonds, the price goes up, yield goes down because there is an increase in demand.

    Excess supply causes bonds to sell at a discount.

    Excess supply, lower price, higher yield. Higher yields at the long end of the yield curve typically increase mortgage rates. An increase in yield on the 10-year typically directly causes an increase in mortgage rates % for %.

    Credit cards are typically attached to LIBOR or Prime rate. LIBOR is almost an international Fed Funds rate. That is the rate that banks lend money to each other to smooth the balance sheet out. LIBOR + 8% means that they are paying LIBOR or Fed Funds rate to fund the cash for your card, then the 8% is based on your credit score. They pool all the people with your credit rating and say we expect 5% defaults at this score, we change 8%, and have a 3% typical or expected profit.

    Then prime rate I THINK is the 90 dayA1/P1 commercial paper rate. That's also a short term liquidity issue. If that credit company is tapping the commercial paper market then they are paying 3.25% (I think thats prime right now) to have the capital to fund your credit card. So they pay 3.25% for the money, then based on credit the 8%...

    Anything 2 years or longer should be coupons, so they would not compound unless you re-invested the dispersement into more bonds.

    Source(s): www.treasurydirect.gov www.federalreserve.gov www.bls.gov www.ustreas.gov
  • 1 decade ago

    A bond is really nothing more than a loan to a business or government entity. With a business, it is secured by real property. The affect that is has is that in the event of a business failure, bond holders are paid first, then equity holders.

    Don't think of a bond as an equity holding. Your bond will pay face value at maturity. Coupons are additional interest earned on the bond.

    The US Gov't has always had a history of paying up when bonds mature. However, there is really noting backing those bonds except the faith that bondholders have in the US Gov't.

    If all of the bonds held by China were for sale, it would mean that all of the Chinese leaders have alzheimers. They would take a beating on the selling price and they would loose their hold over the USA on trade issues.

  • Anonymous
    1 decade ago

    What bonds are worth, once issued, is determined by the bond markets. If you hold that 30-year bond to maturity (and assuming that it's a fixed-rate 4% interest bond), it will pay you 4% interest per year and then you get your original principal back at the end of 30 years. If you sell the bond before that time, you will only be able to sell it for whatever the current market will offer for it. The market value is a function of several things, but mainly the interest rate the bond pays compared to current rates.

  • 1 decade ago

    Its not excess supply that would drive the price down. The price of China's bonds will depend on if their interest rate is more or less than your "current" 4% bond. If their bonds only pay 2% interest, no one is going to buy them at full $10,000 price when they can get 4% interest ($400 per year) from a bond like yours. So their price will have to come down to $5,000 so people would be able to buy 2 of their $10,000 (at maturity) bonds to equal the 4% or $400 per year rate.

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  • Anonymous
    4 years ago

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