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Author: pauleckler Big funky green star, 20000 posts Top Favorite Fools Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35387  
Subject: Re: Why should bond prices drop? Date: 1/14/2005 3:06 PM
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"On the other hand, if Microsoft is earning $1 per share per year(imaginary numbers here), and suddenly everyone in the market learns that Microsoft if going to earn $2 per share for the next year (when they previously believed it would be $1.10), then the stock price will go up now as opposed to next year (with some discounting for the chance that it wont actually be $2).

However, I've heard some interesting arguments about why this type of thinking may not apply to the bond market. But, does this mean that in a period of decreasing interest rates, one could make short term profits by buying before the rate decrease and then selling after. Or would this not work because the price wouldn't change, say, the day of the interest rate change, but over a period of time? Long term it wouldnt be a good idea because you would be decreasing the interest rate that you could get (unless you never planned to keep the money in bonds in the first place). Since, as far as I know, you can't sell short bonds, this wouldn't really apply to increasing interest rates."

This comparison gets very complicated because stock prices respond primarily to earnings expectation. When future earnings are expected to increase, the price increases. When future earnings are expected to fall, the price falls. Hence, the value of Microsoft stock is determined primarily by its price earnings ratio.

When companies fail and head toward bankruptcy, or stop earning, their value then tends to be determined by the resale value of their assets, which theoretically is approximately their book value.

Hence, when Microsoft pays out a large dividend, that reduces its assets and hence its stock price. But because its value is determined primarily by earnings and the dividend does not affect earnings, you expect the effect of the dividend to be short term.

Bonds on the otherhand are valued by their ability to pay market interest. As they are a contract to make fixed interest rate payments at specific times, interest rate changes change the market value of the security. The market does anticipate these changes, but the relationships are not the same as for stocks.

"But, does this mean that in a period of decreasing interest rates, one could make short term profits by buying before the rate decrease and then selling after."

Yes, when rates are declining those who own bonds certainly do get capital gains on paper from those decreases. The problem bond traders have is that if you sell one bond to take these profits and then buy another bond, its price too has been affected. Hence, the gain is transitory. You need another investment for your money that is not affected by interest rates to succeed. Otherwise, you need to anticipate events like changes in bond ratings that do not affect the value of other investments.
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