Theoretical High Price of a Bond

[Peterb6086]

I'm podering if there is a theoretical high price for a bond, say a 20 year Treasury. One would think that the yield approaching zero would do it. But then again, is there anything to stop a bond price from going negative? It happened in Japan two years ago.

[Bradly T.]

Not sure I understand the question since EVERY bond issue has a negative "return" potential based on market pricing and interest rate risk if sold prior to maturity. A negative "price" would indicate a bond owner would pay someone to take possesion of the issue as opposed to selling at a discount to par. No point. Hold until maturity and redeem at par. Except of course for the default risk of some issues taking price/value to zero or pennies on the dollar. Can one lose more than their purchase price by owning any bond? No. Bondholders incur no creditor or ownership risks of the issuer. Illiquidity is a very real risk for individual bond purchasers...no one will buy regardless of discount. Perhaps I didn't understand the question??

[Peterb6086]

hey Bradley, it's been a while. Hope all is well.
I didn't quite state the question correctly.

If 10 or 20 year rates drop again, bond prices going up. If rates start to approach zero, this should theoretically put a limit to the upside price potential. But then, some crisis could push prices up more since treasuries are the safehaven. This could cause negative yields as it did in Japan and cause, as you stated, people to "pay for safety of treasuries". Could you see this happening or is there a realistic high to a bond price ie a low for yields? Assume the treasury has to be sold at some point and can't be held to maturity.

[Bradly T.]

I'm sure I read that short Treasury buyers did just that during the swan...paid a bid up price that guaranteed a loss at par maturity. And yes, there are plenty of "safe-haven" scenarios in the global economy's future....gold is the biggest beneficiary right now. Gold costs around $400 oz. to produce/extract and sells at a $1000/oz. premium to cost due to investor's fears over sovereign debt and currency values. And China is "hoarding" commodities not actually needed now and driving up price because they have the cash to pay and compete....for now (and inventoried commodoties allow future price/market manipulation opportunities - I'd hate to be the guy trying to outwit or outwait the Chinese). Price and currency wars will make speculating and concentration strategies damn dicey in the decades to come. An old saying with futures traders is..." the best cure for high prices IS high prices".


There is no intrinsic value determining price of anything right now....it's all about perception, momentum, and the acceleration or collapse of either the supply or demand side. There's plenty of gold in the ground and in the vault and there's an ever increasing supply of currency. That increasing supply of depreciating currency is chasing risk returns, especially in energy and commodoties (and most especially gold), and there is some probability that both currency and commodoties implode simulteaneously......making both worthless essentially to owners of either. Then the full faith obligation of Uncle Sam becomes the darling again....even at zero or negative yield. But that's probably over in another decade or so if Uncle Sam doesn't start paying his bills with cash flow rather than debt. To the degree that investor fear or greed drives commodity pricing, volatility will be extreme. While a strong dollar is bad for many strategies, it's still real good for one....oil pricing....and maybe another - Uncle Sam's ability to sell debt obligations. But the more attractive our debt is, the more we will likely use it....to our detriment.



Disclaimer: I'm obviously no economist and don't presume to understand the delicacies or intracacies of these tectonic forces. I'm merely a fascinated student. I don't manage client allocations based on all the what ifs....and no reader should sure as hell believe a damn thing I have to say about it either. To live long and prosper - expect the unexpected and embrace the certainty of uncertainty.

[Tad Borek]

Peter, there's a very quick answer to your question as long as you don't go negative: add up all the cash flows. The total is the present value of those cash flows with the yield at 0%. Example, $1000 bond, 5% coupon, five years - at 0% yield the price is $1250. You're handing over $1250 and getting $1250 back. So if you assumed yields no lower than zero, that would be the ceiling on the price of the bond. As Bradly noted this ignores "real returns," it's strictly the PV of those cash flows.

Can yields go negative? With "known" deflation, yes, but not just then. Recently T-bills have sold at negative yield and much ado has been made of the fact that TIPs hit negative base yields. The former may simply reflect the need of large investors to park short-term reserves somewhere absolutely safe, and a willingness to accept storage costs in exchange for that security and liquidity (anyone with a bank account paying monthly fees arguably is in a similar position). The TIPs pricing may reflect what "someone" is willing to pay for a Treasury-guaranteed call option on the CPI. I have no idea who was on the other side of those negative-yield TIPs auctions but it seems possible that the bond's CPI lever could have been valuable to someone at the time, as a hedge or as something bundled in another product that was sold at a markup sufficient to justify the cost. Overpriced inflation-indexed annuities, or perhaps derivatives based on CPI...who knows?

Some quick Excel work will produce a calculator that shows the price of a given bond at different yields. Use the XNPV() function, with the new rate being the first argument in the parenthesis, and columns consisting of the dates and cash flows. It'll blow up if you try to solve for a negative yield because of the math behind that function. Excel doesn't like deflation I guess.

I do some work around finance apps - here's a little "workbench" app I did awhile ago to work out some bond math, that shows the price changes you're asking about, at least for a range of current yields above 0%. Its math also blows up at 0% so it nulls everything out in the display rather than showing the right answer. (The real app will be a lot nicer but isn't ready for prime time.)

-Tad

[kabir14]

I am asking a little different Question. I hope it is the right place.
what is happening to municipal bonds now and in the next 10-20-30 years.
is Meredeth Whitney research coming into play

[Bradly T.]

Interesting question.....and the answer depends on single issues, index funds, active funds and the skill of the active fund manager. Some believe that increasing tax rates and lower issuance will be a significant counterbalance to the interest rate cycle effect for munis. So demand may offset pricing pressures. It is rightly believed, and well documented, that a bond index fund is THE VERY WORST strategy for participating in the fixed income universe for multiple reasons - but especially the internal weighting of the index. Certainly, active managers have many ways to offset the interest rate cycle to come - continuous purchase of new coupons, duration of issues bought, credit risk spreads, put bonds, and hedging strategies will combine to counter the old-issue pricing challenges. But not all are as skilled as some....choose your bond funds and managers well....very, very well. And do NOT believe that equity income is any substitute for fixed income allocations.


That's munis....but there are many ways to apply fixed income allocations into positions that neutralize or profit by the upward interest rate cycle. Floating rates, convertibles, foreign sovereign and corporate, BDCs, and other issues are far more user friendly. A tactical allocator with a strategic allocation, over weights the elements WITHIN the strategic allocation based on current inflation and interest rate cycles. But it is generally agreed, we're at the bottom now. What is not clear is how and when economic growth and expansion and renewed prosperity will drive the cycle. How high, how fast is NOT clear TO ANYBODY!! To predict the unpredictable is damn foolishness and counterproductive.....man, my clients have made a lot of money in long munis and Treasuries DESPITE prediction to the contrary. Even Bill Gross has his pants around his ankles, looking a little silly for concentrated timing and prediction in a very unpredictable environment.

[fxtrader1979]

I am asking a little different Question. I hope it is the right place.
what is happening to municipal bonds now and in the next 10-20-30 years.
is Meredeth Whitney research coming into play

I have researched this topic extensively and from everything I am reading Meredith Whitney has been dead wrong on Muni's. She predicted "hundreds of billions" of dollars of defaults in 2011 and what took place was a small fraction of that. When we hear numbers relating to municipal bond defaults in the hundreds of millions of dollars it sounds like a huge deal. When taken in the context of the overall market however this is a fraction of a percent of the close to $4 Trillion in outstanding municipal bonds.

Thats my two cents.

Thanks
Dave