The Fed and the Markets (Part 2)

Friday, August 18, 2017

By: Christopher P. Cline

We’re looking at the effect of the Fed’s actions on the stock and especially the bond markets.  In the first installment, we looked at how the Fed promotes economic growth and price stability.  In this part, we look at how stocks and bonds are valued, and how economic factors (including those triggered by the Fed) move those values.

Bonds

Because the Fed’s primary tool for promoting growth and stability is the setting of short-term interest rates, its actions have the greatest effect on bond prices.  So let’s examine the basics of bonds.

A bond is simply an IOU, from either a corporation or a governmental entity.  The investor “lends” the face amount on the bond to the entity issuing the bond for a set period of time, and the entity agrees to pay a fixed interest rate over that period back to the lender.  At the end of that period, the entity pays back the “face amount” of the bond (the amount originally lent). 

Bonds are used by the U.S. government to fund its operations, by municipalities to fund infrastructure and by corporations to fund expansion plans.  Bonds are considered safer than stocks because corporate bonds have to be paid back first in the event the company defaults (ahead of shareholders), and because government bonds are backed by the full faith and credit of the government issuing the debt.  Having said that, cities and municipalities, as well as corporations, have filed bankruptcy, which can render bonds worth less (or worthless).

The most important types of bonds are those issued by the U.S. government.  Known as “Treasuries,” they come in various lengths:  Treasury Bills (or “T-Bills”) have terms less than two years (typically measured in weeks); Treasury Notes have terms between two and ten years; and Treasury Bonds have terms of ten years to thirty years (the term “Treasury Bond,” if not stated otherwise, tends to refer to the ten-year bond, while the thirty-year bond is sometimes referred to as the “long bond”).  Treasuries are important because they are a measuring stick for comparing returns of other securities (both stocks and bonds).  They have this baseline status because they are considered risk-free (the U.S. government has never defaulted on its obligations).

Bond Basics

To understand how the economy affects bonds, it’s important to understand some basic concepts:

• Interest: The rate, expressed as a percentage of the face amount, that the bond issuer pays to the bond holder (payments are typically made semi-annually). This is sometimes referred to as the coupon because bonds used to have actual coupons attached to them, that the holder would cut off and present for payment (which is also where the term “clipping coupons” came from).
• Face Amount: This is the amount of principal that is both the original purchase price of the bond when it’s issued and the amount that the bond issuer must pay back at the end of the bond term. Also referred to as “par value,” the face amount is not the same as its market value (the price that an investor might pay for it on a secondary market, discussed below).
• Maturity Date: The date on which the bond must be repaid at par value. A bond’s lifespan is known as its “term to maturity.” For example, a 25-year bond has a 25-year term to maturity when it’s issued. Five years after it is issued, it has a twenty year term to maturity.
• Duration: This is a hard one. First, it is NOT the bond’s term to maturity, even though it sounds like it should be. Rather, duration captures a bond’s underlying price volatility: the shorter the duration, the lower a bond’s price volatility, and vice versa. A detailed discussion of duration is beyond the scope of this paper, so just be aware that it is more a measure of volatility than term, and that a shorter duration usually is better.
• Credit Rating: Bonds are rated (primarily by either Standard & Poor’s or Moody’s) based on the creditworthiness of the bond’s issuer. The better the credit rating of the issuer, the lower the interest rate it has to offer to entice investors to buy.

Bond Pricing

Although when bonds are originally issued, they tend to sell for the face amount, most bonds are sold in a secondary market, either individually or as part of a bond mutual fund, after they’ve been issued.  All bonds after original issue are priced according to the present value of their future cash flows.  In essence, an investor decides his or her required rate of return (often based on market-rate returns of new bonds being issued), and then compares this rate to the rate of a particular bond being considered.

Let’s take an example.  I have the chance to buy a bond that pays 2% of the face amount (let’s say $1,000).  But new bonds of a similar nature and quality are paying 3%.  I’m not going to pay $1,000 for this 2% bond; instead, I pay a smaller amount so that the $20 coupon payment equals a 3% return.  This smaller amount is $666.67 (in other words, $666.67 x .03 = $20).  In this case, the bond is sold at a discount to its face amount.  (It’s a good time to introduce a new term:  Current Yield.  If I only pay $666.67 for a bond that pays $20, my Current Yield is 3%, even though the coupon rate is only 2%, because I didn’t pay the face amount.)  On the other hand, if I have the chance to buy the same bond at a time when similar new bonds are paying a coupon amount of only 1%, I’d have to pay a premium (the $1,000 bond paying 2% would now sell for $2,000). 

This leads to two important points.  First, and most important to remember, if bond yields go up, it means that bond prices are going down, and vice versa.  So when you read in the Wall Street Journal that the yield on 10-year Treasuries is going up, it means that their prices are going down.  Which is good if you want to buy one, but bad if you already own one.

Second, although bond prices go down when rates go up, and up when rates go down, the example above shows that they don’t move at the same rate: bond prices go up faster than they go down.  In our example, a 1% rise in rates dropped the price by a third, but a 1% drop in rates doubled the price.

Note that interest rates are not the only thing that affects bond prices.  A downgrade in the credit rating of a particular bond issuer can cause the price of its bonds to fall.  Differences in the duration of two similar bonds also can affect their prices relative to each other, because one is perceived to be more volatile than the other.

Bond Investing

In general, there are three ways an investor can view bond purchases.  First, an investor can look mainly to the income the bonds produce, conservatively looking to maximize income (usually to live on).  Second, an investor can speculate by buying bonds to capitalize on anticipated rate changes.  In this case, bond investing can be very risky (even though bonds are usually perceived to be safer investments) because no one knows for sure which direction rates will move or when.  Third, long-term investors seek a total return from their bond portfolios, looking both to the income the bonds produce but also the increase in the portfolio’s value over long periods. 

Moves in short-term interest rates by the Fed can impact these different investing styles in different ways.  If the Fed increases rates, it will tend to lower the price of existing bonds.  An income-based investor who plans to hold her bonds to maturity may not be very concerned, while a speculator may be betting for or against such a move.  A total return investor may make some changes to a portfolio as a result of the change, but probably not significant changes.

Stocks

Compared to bond investing, stock investing is more intuitive.  Stocks are simply an ownership interest in a company: if you buy a share of Apple stock, you own a very small piece of that company.  The return that you get from that ownership interest comes in two forms: the dividends that the company issues, and the growth in the value of the company itself.

Stock purchases are often made through mutual funds or exchange-traded funds (known as “ETFs”), which are collections of stocks.  So when you buy a mutual fund or ETF share, you are holding very small interests in all the stocks that the fund owns.  These come in two forms: managed funds (where a fund manager is using his or her specific knowledge to select stocks that he or she believes will outperform the market); or index funds (where the fund simply buys all the stock of a given index, like the S&P 500, in order to passively gain a return equal to that of the market that the index represents).

As a result, stock prices are a function of two factors: how well the company itself is performing (its earnings, sales growth, expansion, and so forth); and its inclusion in a particular fund or index (in other words, even if a company isn’t performing very well, if it’s part of the S&P 500, its price could still go up a little, or not drop as fast, as investors buy the index as a whole). 

Fiscal and monetary factors strongly influence share prices (when interest rates go up, companies find it more challenging to borrow money to fund expansion plans), but not as directly as rising interest rates influence bond prices. 

For instance, if the government enacts corporate tax cuts and engages in infrastructure spending, it can cause the economy to heat up, raising the value of stocks.  And although the Fed might respond to these fiscal actions of the government by raising short term interest rates, the dampening effect of increased borrowing costs to businesses would usually be more than offset by the overall benefits of a lower annual tax bill and the increased revenue from government contracts. 

Indeed, that is exactly what fueled the jump in stock prices immediately after President Trump’s election: the mere promise of tax cuts and infrastructure spending was enough to raise stock market prices significantly.

* * * * *

In our third and final installment, we’ll look at the Fed’s actions in 2017, and how they have (and have not) affected the stock and bond markets over the past eight months.