Tuesday, September 27, 2005

Please Don't Devalue My Bonds, Mr. Greenspan.


Sophisticated investment and financial professionals sometimes talk about the “Greenspan Put”. Distilled to its essence, this means that the current Federal Reserve will ratchet up Fed Fund rates until they believe that the last “dog of inflation” has been choked. At that point, the Fed will lower rates quickly and ease the pain on bondholders. That, distilled to its essence, is what the “Greenspan Put” is all about. Just ride out the interest rate increases and Alan will then quickly lower rates and bail you out.

But it occurs to the Author that many of the concepts and terms that go into the “Greenspan Put” might use some review and discussion. The Author, in wishing to be brief for his busy readers, and requiring some space for his vapid humor, sometimes bypasses points that would be worth further explanation. The Author’s first task is to educate and entertain his readers and to help them to understand investment, financial and economic matters. So let’s go through some of the key concepts that underlie the “Greenspan Put”.

A. Alan Greenspan and the Federal Reserve. The Federal Reserve, or the Fed, is the central bank of the United States. It has 12 member banks and a Board of Governors. Alan Greenspan is the Chairman of the Board of Governors. The Fed has several responsibilities, but for those in the financial and credit world, the activities of the Federal Open Market Committee (FOMC) are what are scrutinized. The main charge of the FOMC is influencing money market (short-term) interest rates and credit. The FOMC does this by setting the “federal funds rate”, commonly called the “overnight rate”. This is the amount that Federal Reserve member banks charge each other for overnight loans. So when the news media refers to raising rates, they mean that the FOMC raised the “overnight rate”.

B. Put. A put is the right to sell a stock or commodity at a defined price at some point in the future. A put gives the put owner protection if the price of the stock or commodity falls. Let’s say we own 100 shares of GWAR Inc. and we paid $30 per share for it. If we are concerned the price of GWAR will fall, we can buy a put to sell 100 shares of GWAR at a “strike price” of $35. This strike price gives us the right to sell GWAR at $35 per share even if the price of GWAR falls to $10.00. We can buy Puts with other Strike prices, higher or lower that $35.00. This was just an example. Put and calls are traded on options exchanges and can be an important part of an investment portfolio. But in explaining the Greenspan Put, this “Put” means that the Fed will quickly lower rates after raising them and the price of bonds will rise back up in price. In effect, the Fed will give bondholders “downside” protection.

C. The Correlation Between Interest Rates and Bond Prices. Bond prices and interest rates move inversely to each other. So when interest rates rise, the price (value) of bonds fall. Similarly, when interest rates fall, the price of bonds go up. Here is why:
Bonds are usually issued with a standardized value (“par”) value and with a fixed interest rate and fixed term of the bond. Let’s assume that we buy a bond that has a term of 10 years, a par value of $1,000 and pays annual interest of 5%, or $50.00. For 10 years we will get 5% interest. And at the end of the 10 years, we will be paid back the $1,000, the par value of the bond.
A year after we buy the bond, interest rates rise to 7%. The current price (value) of our bond will fall. Remember, our bond pays 5% interest when we could go out in the bond market and spend a $1,000 for a bond that will pay 7%. If we wish to sell the bond, we will have to drop the price. Our bond will sell at a “discount”.
Two years after we buy the bond, interest rates have fallen to 4%. Now the value of our bond will rise. Since our bond pays 5% interest ($50.00) and the other $1,000 bonds only pay 4% ($40.00), our bond is worth more money. Our bond will now sell at a “premium”.

So lets put this all back together. When the Fed raises the overnight rate, this increase will in turn raise other interest rates, and bonds will fall in price. But the Fed will save us in the end with the “Greenspan Put”. After raising rates it will quickly drop them again, lowering interest rates and raising the value of bonds.


In yesterday’s post, the author mentioned that David Letterman was disappointed when the name of Joey Buttafuco fell from the headlines. And the “conundrum” (the paradox of high-short term interest rates and low long-term rates) has gotten trite and cliché. So hereinafter, “the conundrum” will be referred to as “The Buttafuco”.