I was reading The Intelligent Investor, I have a question on this quote.

[Debronic]

Basically, investors always require a certain risk premium to buy a bond on top of risk free interest rates. When interest rates rises and assuming that the risk premium does not change, the yield that investors would require to buy the same bond would increase. And because the cashflows (i.e. bond coupons and redemption payment) of a bond already issued in the market are fixed, this means that the market price or present value of the same bond should decrease as you are discounting the same cashflows back using higher required yield. Hope this helps.

[tanjm]

This is a time value of money question. To truly understand it, you need to go back to first principles.

Answer this question:
If I am promised $100 (risklessly - i.e. the $100 is gauranteed) in one years time, what is that promise worth to me now?

The no-arbitrage argument : I need money **now**, so I pledge the $100 in one years time to a "bank" that will lend me some money now. So that money logically is worth what the bank is willing to lend me.

If you are a bank, and you can borrow money at a rate of 1%, then the $100 due to the bank in one years time is worth 100/(1.01) = $99.01 **now**. This is the bank's present value of that $100 cash. If the bank can only borrow at 2%, then the present value is 100/1.02 = $98.04 **now**.

If you are an individual, you may only be able to borrow at 5%. Then the present value of that $100 is just circa $95.

If you are evaluating a market opportunity (such as a bond), then you need to use some kind of averaged rate that everyone uses since everyone is potentially bidding for that asset.

In all cases, the use of a higher rate will mean that future cashflow is worth less now. A bond is just a collection of future cashflows.

[Temperament]

Regardless of all the established theories in calculations, when financial calamity striked like in 2008/2009, there were many people willing to foregone any interest or even willing to accept negative interest. They put their cash into "FED TREASURY"
So now if you have too much liquidity(cash), where you are you going to "safe -keeping it? CPF? Corporate bond? Bank TD? The best CA of a bank that gives you some interest? Or what?
i think each individual will consider an appropriate suitable action.
Theory is for guidance only.
Theory and practice always have some differences. No hard and fast rules for me.
Shalom.

[tanjm]

Regardless of all the established theories in calculations, when financial calamity striked like in 2008/2009, there were many people willing to foregone any interest or even willing to accept negative interest. They put their cash into "FED TREASURY"
So now if you have too much liquidity(cash), where you are you going to "safe -keeping it? CPF? Corporate bond? Bank TD? The best CA of a bank that gives you some interest? Or what?
i think each individual will consider an appropriate suitable action.
Theory is for guidance only.
Theory and practice always have some differences. No hard and fast rules for me.
Shalom.

The original question was a question about basics.

Just because the Special Theory of Relativity explains space and time including special cases doesn't mean newtonian mechanics is invalid or worthless. You need to know the basics before you can decide to throw away the rulebook. All complex systems need to be approximated with linear calculations with the knowledge of what to do when non-linearity (e.g. tail events) creeps in.

And in fact, textbooks typically assume one discount rate for TVM. My example is reasonably real world as it applies it to the case of people with different funding costs.

[Temperament]

Regardless of all the established theories in calculations, when financial calamity striked like in 2008/2009, there were many people willing to foregone any interest or even willing to accept negative interest. They put their cash into "FED TREASURY"
So now if you have too much liquidity(cash), where you are you going to "safe -keeping it? CPF? Corporate bond? Bank TD? The best CA of a bank that gives you some interest? Or what?
i think each individual will consider an appropriate suitable action.
Theory is for guidance only.
Theory and practice always have some differences. No hard and fast rules for me.
Shalom.

The original question was a question about basics.

Just because the Special Theory of Relativity explains space and time including special cases doesn't mean newtonian mechanics is invalid or worthless. You need to know the basics before you can decide to throw away the rulebook. All complex systems need to be approximated with linear calculations with the knowledge of what to do when non-linearity (e.g. tail events) creeps in.

And in fact, textbooks typically assume one discount rate for TVM. My example is reasonably real world as it applies it to the case of people with different funding costs.

Of course, of course. One must knows the basic principles well. i am not disagreeing with learning the principles of anything well before one can be flexible about it. No intention to offence anyone at all all. Remember i said each one will apply the best practical solution to each's circumstances regardless of the basic principles.

i also said for me (i left out the "only"). But it obvious as i had said applicable to each his own circumstances.
My apology if i offense anyone at all.
Cheers!

[beau]

Basically, investors always require a certain risk premium to buy a bond on top of risk free interest rates. When interest rates rises and assuming that the risk premium does not change, the yield that investors would require to buy the same bond would increase. And because the cashflows (i.e. bond coupons and redemption payment) of a bond already issued in the market are fixed, this means that the market price or present value of the same bond should decrease as you are discounting the same cashflows back using higher required yield. Hope this helps.

Hi Debronic,

I do understand this concept, thank you very much for explaining. So back to the original post, this makes bonds more attractive compared to bank interest rates, because the bond prices are now lower?


Also, the interest rates you get in real life in banks are so low. Why does the book seem to compare them with much higher bond interest rates? Or is this not applicable in this day and age?

[Debronic]

Basically, investors always require a certain risk premium to buy a bond on top of risk free interest rates. When interest rates rises and assuming that the risk premium does not change, the yield that investors would require to buy the same bond would increase. And because the cashflows (i.e. bond coupons and redemption payment) of a bond already issued in the market are fixed, this means that the market price or present value of the same bond should decrease as you are discounting the same cashflows back using higher required yield. Hope this helps.

Hi Debronic,

I do understand this concept, thank you very much for explaining. So back to the original post, this makes bonds more attractive compared to bank interest rates, because the bond prices are now lower?


Also, the interest rates you get in real life in banks are so low. Why does the book seem to compare them with much higher bond interest rates? Or is this not applicable in this day and age?

Hi beau

My answer above as in response to some previous postings on bond pricing.

Regarding your questions, I do not believe there is any reference to bank interest rates. When we say interest rates, we are typically referring to a benchmark such as Fed rates.

As to your original quotes, I am not exactly sure under what context they appear in since I read the book 10 years ago. But if I were to interpret it, it is saying that if interest rates rise, the PV (calculated value not price) of stocks would become lower which makes it less attractive compared to investing in bonds which would become more attractively priced due to higher interest rates.

In practice though, the relationship between bonds and stocks is a lot more complex and there will be times where they move in tandem because both are considered "risky assets" such as during the last financial crisis.

[beau]

Basically, investors always require a certain risk premium to buy a bond on top of risk free interest rates. When interest rates rises and assuming that the risk premium does not change, the yield that investors would require to buy the same bond would increase. And because the cashflows (i.e. bond coupons and redemption payment) of a bond already issued in the market are fixed, this means that the market price or present value of the same bond should decrease as you are discounting the same cashflows back using higher required yield. Hope this helps.

Hi Debronic,

I do understand this concept, thank you very much for explaining. So back to the original post, this makes bonds more attractive compared to bank interest rates, because the bond prices are now lower?


Also, the interest rates you get in real life in banks are so low. Why does the book seem to compare them with much higher bond interest rates? Or is this not applicable in this day and age?

Hi beau

My answer above as in response to some previous postings on bond pricing.

Regarding your questions, I do not believe there is any reference to bank interest rates. When we say interest rates, we are typically referring to a benchmark such as Fed rates.

As to your original quotes, I am not exactly sure under what context they appear in since I read the book 10 years ago. But if I were to interpret it, it is saying that if interest rates rise, the PV (calculated value not price) of stocks would become lower which makes it less attractive compared to investing in bonds which would become more attractively priced due to higher interest rates.

In practice though, the relationship between bonds and stocks is a lot more complex and there will be times where they move in tandem because both are considered "risky assets" such as during the last financial crisis.

Thank you. So essentially this is a comparison of DCF/discounted earnings of stocks versus bond yields.