For Debt Instruments: Time is Money

We have all heard the expression “time is money.” In the world of debt obligations, bonds , notes and mortgages, this is literally the case as there is a mathematical relationship between time, money and the rate of interest.

In the old days, when I first broke into the bond business, before there were computers and bond calculators on every desk, bond prices were looked up in something called a basis book. These books had pages filled with columns of numbers where you could look up the price of a bond if you knew the stated interest rate, maturity date and the yield to maturity. Back in the late ‘60’s when I first started out, municipal bonds literally had coupons attached to the bond that were cut off, sometimes referred to as clipping off the coupon, and presented every six months for a half year’s interest payment. The municipal bonds in those days were in bearer form and smart people kept them in a safety deposit box. It was years later that book entry replaced bearer bonds. Today with computers, I think almost if not all bonds are in book entry form.

Bonds and notes have a dated date from which the time they start paying interest, at a stated rate, is calculated. This interest rate was referred to as the coupon rate. Every bond has a maturity date, the date at which the principal and final interest payment are paid. When interest rates go up in the market, bonds already in the market come down in value (price) as the principal value must be shaved in order for the bond to be in line with the yields of the newer bonds coming to market. When a bond declines in value from its face amount, usually $1,000, it is said to be selling at a discount. Prices move both ways, up as well as down. When interest rates fall, bond prices move up in value (price) as they come in line with the newer debt offerings. This is known as the inverse relationship that yields have to price.

One percent (1.00%), is made up of 100 basis points. When a bond goes down in value because interest rates are going up, the yield to maturity of the bond goes up. A 5.00% bond, whose price falls from par (100.00), will experience an increase in yield, known as the yield to maturity. An increase in interest rates across the bond market will mathematically reduce the price (value) of bonds in the market. The longer the maturity of the bond the greater the price decline for each basis point that interest rates increase. I will discuss the yield curve and what it means another time.

Several factors can move the price of a bond, or for that matter the market. The movement of interest rates by the Fed is only one of those factors. The Fed can influence interest rates through the use of it tool bag, but other factors like credit worthiness can be beyond its control. There is a whole discussion of credit and debt and their relationship to price that has not been tackled. There is a direct relationship between credit, debt, yield, maturity and price. And, credit worthiness and the credit ratings given debt instruments by the ratings agencies, one of the non-mathematical parts of the equation. This is some of what is behind the present sub prime mortgage mess. Stay tuned.