I explain to mrs_horseman the mechanics of negative interest rates.
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by hedgeless_horseman
Fri, 08/02/2019 - 13:28
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If your only tool is a printing press, every problem is deflationary.
-hedgeless_horseman
There was an interesting article on ZeroHedge this morning, with some great comments from y'all.
Entire German Curve Drops Below Zero For First Time Ever
https://www.zerohedge.com/news/2019-08-02/entire-german-curve-drops-bel…
It is difficult for most people to wrap their heads around negative interest rates. I have made several attempts at explaining the phenomenon, most recently in a conversation with the lovely mrs_horseman, while enjoying a wonderful Monsoon cocktail on the front porch swing during a hot and humid Texas evening.
Allow me, dear ZeroHedge readers, to present to you my very own invention, the wettest of all martinis, for the hottest and most humid of days, the Monsoon.
https://www.zerohedge.com/news/2019-06-03/alcohol-my-yoga-baby
First, I said, let's review the basics of what a bond is, and how it functions.
A bond is simply a loan agreement between a borrower and one or more lenders. It has an initial loan amount called the par value, an annual payment amount called the coupon, and a date called maturity, when the loan is to be paid back in full. To keep the math simple, let us use the following for our illustration:
Borrower: Wonder Marital Aids, Inc. (WONK)
Par Value: $10,000
Coupon: $400 per year in $100 quarterly payments
Maturity: 7/31/2029 10 years from issuance
From this information we can calculate the initial interest rate. Pay attention, as this calculation is important, if you want to understand negative interest:
$400/$10,000 = 4.00%
So, when the bond was issued last month, lenders gave WONK $10,000 for each bond they wanted to purchase. In exchange, WONK agrees to pay the owner of the bond, which may or may not be the initial buyer, $100 every quarter, and also pay back the $10,000, in ten years. So, over the duration of the bond, the borrower is obligated to pay:
$400 X 10 years = $4,000 in interest, plus $10,000 at maturity, or $14,000.
Thus far, what we have covered is objective. It is just math. Now, we need to talk about how the bond market is supposed to work, which is subjective, by definition of the term, "market."
Often times the lender does not hold the bond until maturity, but rather sells it in the marketplace at a price that is subject to supply and demand. For example, let us imagine that one year has passed since issuance. Initially, the rating agencies gave these 10 year 4% WONK bonds an A rating. However, WONK's vibrator business is really humming! Wall Street analysts all agree that WONK should have no problem making its payments to the bond holders, and have raised the rating to AA. In theory, higher risk borrowers pay a higher interest rate, so with WONK's risk of default decreasing, the bonds should trade at a lower interest rate. Said another way, lenders should be willing to pay more for a safer investment, so with WONK's risk of default decreasing, the bonds should trade at a higher price.
Keeping the math simple for illustration purposes, let us say that $10,250 is the new market price at which an investor buys the AA rated WONK bond, which now pays a 3.90% interest rate.
$400/$10,250 = 3.90%
However, if WONK's business wasn't doing so well, and Wall Street downgrades it to BBB, then an investor might only be willing to pay something like $9,750 for the bond, which will then pay a 4.10% interest rate.
$400/$9,750 = 4.10%
It is easy to see why the interest rate and price of a bond move in the opposite direction, like a teeter totter. It is just math.
more,,,,,,,,,,,,,,,
http://www.zerohedge.com/news/2019-08-02/i-explain-mrshorseman-mechanics-negative-interest-rates
Realist - Everybody in America is soft, and hates conflict. The cure for this, both in politics and social life, is the same -- hardihood. Give them raw truth.
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