The Great Debt Ceiling Debate – Part 2

This is part 2 of a multi-part series on the “great debt ceiling debate” written as an accompaniment to our radio show broadcast and podcast, “Raising the Roof – How the Great Debt Ceiling Debate Impacts You”.  You can download the episode on iTunes or find it on our Listen page.

How does the Fed affect the interest rates on Treasury Bonds and why does it matter?

Good question.  We’ll divide our answer into three parts (though we won’t get to them all in this installment):

  1. How Treasury rates affect interest rates on mortgages, corporate and muni-bonds and most all other debt.
  2. How the Fed influences interest rates in the bond markets.
  3. How the money supply is affected when the Fed purchases Treasuries.

After all that (and you should go grab a double espresso to make you stay awake for the whole trip), we’ll talk about what happens if Congress raises the debt ceiling, and what happens if they don’t.  Then as a special prize for your time and attention, we’ll throw out our crystal ball prediction.  So go grab that espresso and hurry back!

1. How Treasury Rates Affect Interest Rates on Almost Every Kind of Debt

Bond prices are determined in the open market.  That means buyers and sellers coming together and negotiating a price.  In actuality, the negotiation is done by auction.  Think e-Bay.

When Uncle Sam (the Treasury) goes into the open market to sell bonds (borrow), investors bid on the bonds.  If there are lots of buyers, the bids go up, which drives yields (interest) down.

The Inverse Relationship Between Bond Prices and Yields

Time out.  Because we teach this at live seminars, this is where some people go “puppy dog” – their heads goes sideways and they get a confused (but cute) look on their faces.  Since it’s important that you understand the inverse relationship between bond PRICES and bond YIELDS, we want to take a minute to explain it.  It isn’t that complicated once you get the math, but it’s important that you understand because once you do, it’s easier to understand which direction interest rates are likely to go and why.

To use extreme examples with simple math:

If you pay $100,000 for a bond (a promise to pay) with a face amount of $100,000 and it yields 5% per year, then you earn $5,000 per year on your $100,000 investment.  If the bond has a 30 year maturity, then at the end of 30 years, you get paid the face amount ($100,000).  You earn interest along the way, then get paid the principal back at the end.  Pretty simple.

Here’s where it gets tricky.

If you have bought a $100,000 bond when yields were 5% and the market changes, then the fair market value of your bond changes.  That is, while the face amount and interest rate stays the same, what someone would actually pay you for your second hand bond in the open market (if you wanted cash now) will depend on what else is available to them at the time.

For example, if new bonds are yielding 10%, then a new $100,000 bond would pay $10,000 of interest per year.  That’s obviously better to the bond holder (the lender) than the $5,000 your old $100,000 bond is paying.

So if you wanted to sell your bond in the open market, you would have to discount it (sell it for less than the face value) until the yield was comparable to the going rate in the open market.  If you don’t, who would want to buy your “second hand” bond?  This is an important principle even if you couldn’t care less about Treasuries because it’s the same principal used with discounted notes, which is a staple for in creative real estate.  But we digress (how unusual!).

Back to bonds.  So if someone wanted a 10% yield on their cash and your bond is paying $5,000 per year, what do you have to sell it for to attract a buyer?  Do you remember the high school algebra you never thought you’d use?  It’s time to use it.

$5,000 = 10% of what?

The answer is $50,000.  Because 10% of $50,000 is $5,000.

Ouch!  That’s a big haircut.  Your $100,000 bond dropped in value to $50,000 in order to pay the same yield.

Now in the REAL world, it’s not that simple.  Because the $100,000 bond will still pay $100,000 at maturity, that also gets factored in.  But it makes the math too difficult for this article.  And then it gets more complicated, because smart investors are going to factor in inflation (the decrease in the purchasing power of the dollar over time).

For purpose of our current discussion, the main point is that when a buyer pays more for a bond, the yield goes down and vice versa.  So when lots of buyers show up (high demand) at a Treasury auction, interest rates go down.  Conversely, when there are few buyers (low demand), interest rates go up.  If you didn’t track with that, take a sip of espresso and a deep breath (not at the same time or you’ll choke), then read it again and noodle through it.  Trust us.  This is important for you to understand, not just as a real estate investor, but as a taxpayer and a voter.

Now the bonus lesson is that when interest rates rise, the value of the bonds you already bought goes down.  Back in March, Bill Gross, the guy who manages the world’s largest bond fund (PIMCO), sold ALL his Treasuries.  Where do you think HE thinks rates are headed?

Treasuries as the Foundation of All Interest Rates

Now, let’s talk about how Treasuries affect interest rates on everything else important to you, like mortgages.

Because Treasuries are considered the world’s safest debt, imagine their yields (interest rate) at the center of a target.  Each ring away from the target is another type of debt.  The farther away you get from the center of the target (ultimate safety), the riskier the debt is.  And the riskier the debt is, the more the borrower has to pay to attract your money away from the center.  After all, as a bond investor, you’re only going to buy something less safe than a Treasury if it pays you better, right?

So you could say that the yields on Treasuries are the foundation for all debt pricing.  When Treasuries go up, it creates a ripple effect to all other debt offerings.  And all the money that people borrow, from mortgages, to cars, to credit cards, etc. all gets packaged up and sold to investors as various forms of bond (to say nothing of derivatives!).  It’s no surprise that the bond market dwarfs all other markets, including the stock market.  In other words the world is swimming in debt.

To bring it back down to earth so you can relate to it, think about it this way:  If you’re a real estate investor sitting on a portfolio of adjustable rate mortgages which you’re using to control millions of dollars of real estate, what happens to your cash flow if interest rates rise?  It drops.

And when more of your rental revenue is being used to pay interest, do you have more or less profit to invest in maintenance, repairs, improvements and new acquisitions? Less.

Take that same principle and apply it to a government.

When a government is sitting on a large portfolio of debt (bonds it has issued), big chunks come due (mature) constantly.  With each set of maturations, the bond holders expect to get paid the face value of the bond.  But where does the bond issuer (the borrower) get get the money to pay off the bond?

If you had a loan come due on a property, you would have to pay it from your savings (Uncle Sam has none), sell the collateral (US bonds are only secured by the “full faith and credit” of the government, so there’s no property to sell), or refinance.  Bingo!  Uncle Sam needs to borrow more.  Just like if you were spending more than you earn and running up your credit cards.  You need the credit card company to raise your credit limit, so you can borrow more to pay off the old credit cards.

And how does Uncle Sam borrow?  He sells bonds in the open market.

Now if current interest rates are higher than the rate of the bonds being paid off (retired), then the interest payable on the freshly issued bonds will be higher, and the debt service (interest payments) will take a bigger bite out of revenue.

But if you, or in this case, Uncle Sam, are already upside down (negative cash flow, i.e., budget deficits), then the rate at which you must borrow increases.  You’re borrowing to pay interest on borrowed money.  It’s a crushing, compounding effect.

Do you see a problem?  It’s a vicious cycle of continual, perpetual debt.  And you either have to find a way to out produce the problem (earn a lot more, as in higher taxes) or you have to make drastic cuts, or both.

That is, unless you have a Magic Checkbook (oooh, ahhh). And wouldn’t you like to know what a Magic Checkbook is?

Join us next time for the next exciting installment of The Great Debt Ceiling where we will discover How The Fed Influences Interest Rates and The Secret of the Magic Checkbook.  Don’t miss it!

Now please pick up your trash and move in an orderly fashion to the exits.  See you next time!

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