Friday, January 14, 2011

The Ten PM Tutorial iii

Yesterday, THG couldn’t make the Ten PM Tutorial for personal reasons—but tonight, here we are, back in business:

Two questions were asked, two shall be answered:

What are bond yields, and what’s a yield curve?

What is “Peak Oil”?

So here goes:

Bond yields are the return on investment that a bond will give you.

A bond is an IOU from either a government (sovereign bonds) or a corporation (corporate bonds). All bonds pay interest, sometimes called the coupon.

Suppose a 10-year bond from XYZ corporation costs $100 at emission, and pays 5% coupon. But two years later, it is selling at $90 dollars. Why is it selling for a lower price? Perhaps the market thinks that XYZ will go broke—it doesn’t matter.

The bond yield is the return you get from buying the bond at today’s market price. Since the bond fell in price, the yield of the bond is 5.55%.

Why? Because $90 divided by $100 equals 0.9. And since the original coupon was 5%, you divide that by 0.9, which equals 5.55%.

So when the price of the bond goes down, the yield goes up. This seems logical: More risk, more reward. More risk, less value in the bond.

Suppose XYZ is doing great—then instead of going down, the bond price goes up. Its original price is not a limitation—it can go up in price past $100. It can go all the way up to infinity (though that never happens, of course).

When the price of a bond goes up, the yield goes down—which makes sense. But here’s how it works: XYZ’s bond was issued at $100, but it goes up to $107.

So $107 divided by $100 equals 1.07. The original coupon was 5%, so 5% divided by 1.07 equals 4.67%.

Often, Treasury bonds (called Treasuries for short; they are the same as Federal government bonds) rise in price in times of crisis: Treasuries are the safest bonds, so people buy them when the other markets are uncertain. Stocks fall? Treasury bond prices rise. If T-bond prices rise, then their yields fall—you see?

Now, the yield curve—click on the diagram above.

You see how the yield changes with time? Remember, a bond is a loan—when you lend money to a friend for an hour, you don't expect any interest, or very little. But if you lend him $5,000 for a year, you expect a little extra.

Same with bonds: Short term debt—which are the same as short term bonds—have a lower yield rate. But longer bonds—that is, bonds that have a longer maturity—that is, bonds that are loans over longer periods of time—have higher yields.

When you map out all those different yields for all those different time periods, you get a yield curve.

The yield curve can tell you a lot: If the yield curve flattens, then it means that the short term yields and the long term yield are getting closer. But it could be that short term yields are rising, or that long-term yields are falling—each of which signals a different thing, depending on different conditions in the market

Same when the yield steapens. The yield curve becomes steep when the short term yield is much lower than the long term yield. This can mean several things, depending on other factors in the economy.

An inverted yield curve is when the bond pays more (has a higher yield) in the short term than in the long term—this happens in exceptional circumstances, again for many different, mutually incompatible reasons.

What I’m trying to say is, the shape of the yield curve tells you different things about the economy—but it can often become as uncertain as reading tea leaves. Often people talk about “yield curve” just to sound clever.

So my advice? Ignore the yield curve if you don’t really understand it, and concentrate on the benchmarks, the bonds that are considered important, like the 10-year Treasury bond: As the 10-year’s yield rises or falls, you see what the market is doing.

10-year Treasury bond yield goes down?—markets are nervous. Stocks are probably falling.

10-year Treasury bond yield goes up?—markets are bubbly. Stocks are probaby rising.

So much for bonds and their yield.

Now—Peak Oil:

Peak Oil is a real but as-yet unknown moment when the maximum amount of oil is being extracted, and so therefore future extractions will be less than past extractions. This doesn’t mean there is necessarily less oil in the ground—only that it will be harder to get that oil out of the ground.

Some people define peak oil as the moment when the cost of extracting the barrel of oil is more than the price of the barrel of oil.

It is impossible to tell when peak oil will arrive—obviously. Many people believe peak oil is the issue facing the economy—but this is not a mainstream view.

The reason peak oil is conceptually important, but practically of no use, is because one, it will happen, and two, no one knows when it happens—no alarm bells will go off. So even even if it has already happened (and most geologists think it has not happened yet), you won’t know it.

When most market participants believe that not only has peak oil arrived, but extraction is rapidly reaching the end of known oil reserves, then the price of oil will rise drastically—stratospherically. And since oil is very necessary to most industry, agriculture, etc., this will be disastrous.

Frankly, it’s a bit like the fear of an “planet-killer” asteroid slamming into the earth: It undoubtedly will happen . . . the only question is when. However, that when could well be hundreds, or thousands, or tens of thousands of years from now.

Insofar as peak oil—and knowing the accessibility of known oil reserves—no one will feel the squeeze for several decades at least.

Hope this helps.


  1. Well, I'll skip the peak oil comments and just move straight to my 10 PM question - What the heck does bond pricing mean? I see comments & quotes of things like 118^25, I have no idea what that means. How are bond prices expressed?

  2. Thanks for this G. Keep up the good work.

  3. According to IEA report last autumn, the peak for conventional oil was 2006, so it should not take decades for us to feel the squeeze. Propably before 2015 according to US army estimates.

    KH Sweden

  4. You are wonderful. Thanks for starting Hourly G and this particular thread of opportunity to learn answers to the sort of questions that are sometimes confusing. - Tess of Kansas

  5. A friend of mine use to be President of a state's Bankers Association. Last summer she commented that the FDIC was broke. Do you think that was an accurate statement?

    When I asked my young small town banker about the FDIC (insurance) being solvent, he assured me that the insurance was good and active, and then he added this magic infomation----he said, (to paraphase) that the banks have had their rates increased to cover the banks that have been closed).

    I think what my banker was actually saying, but not realizing, was...that there was not enough funds to cover the growing risks for the FDIC created by the recently failed and closed banks, sort of like increasing the insurance rates for homeowners who did not have a claim after a hurricane. Any insight you might have for the safety of the FDIC would be welcomed. Can funds in a bank be devalued if it in a FDIC insured bank? Hope these are not too dumb of questions.
    Thanks, T. in Kansas again.

  6. Hi Gonzalo,

    This is just to thank you for answering my question about the price of bonds last week. I can't believe I didn't figure it out myself but mucho obrigado and please keep answering these questions.



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