On the topic of bonds...

I'll be the first to admit that I know nothing about bonds. But the recent thread about GMAC bonds made me start poking around to learn more. I found some information on GM's bonds on their web site:

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Just for the sake of an example, let's look at XGM. According to Google Finance, XGM closed at $5.54 yesterday. That's on a par value of $25. The coupon rate is 7.25% and there's roughly 32.5 years left to maturity.

One interesting thing I noticed is that the bond pays $1.8125 per year in interest. At that rate, it would only take 3 years to earn back the current cost of the bond. In other words, as long as GM doesn't default on these bonds in the next 3 years, you'll at least get your principal back.

But assuming you hold on to the bond until maturity (and GM doesn't default on it), what kind of return will you get? It seems simple enough to calculate. The bond will pay $1.8125 per year for 32.5 years. That's a total of $58.90625 in interest. And when the bond matures, you get the par value back. That's another $25 for a grand total of $83.90625. That makes for an equivalent continuously compounded interest rate of ln(83.90625 / 5.54) / 32.5 = 8.36%.

Except... there's a major difference. In a traditional compounded interest scenario, you have to reinvest your interest. That's not the case here. In fact, the concept of reinvesting interest isn't even applicable unless you consider the case of buying new bonds. So maybe this bond has MORE than an 8.36% rate of return? Not sure how to think about that.

Anyway, that was my first foray in to thinking about bonds. Is all of this correct? BTW, I'm certainly not advocating buying GM bonds. This was just a thought exercise.

Thanks, Bill

Reply to
Bill Woessner
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Yep. That's the trick. If you compute the rate of return assuming you can reinvest the dividends at the same rate, you will get some staggering rate of return. I compute this as 33%. If you could reinvest the interest for 32 years by buying more bonds, and the bonds remain at a yield-to-maturity of 33% you will end up with $47k in principal repayment at the end of the 32 years, 86000 times what you paid.

Of course the market is implying that there is an approximately 30% chance of GM bonds becoming worthless each year for the next 32 years. So the chances of riding this out would be something like 3 in a million. So this is a giant accumulator bet, where you double your money like every 2.5 years, but have a 50% chance of going bust every

2.5 years.

Nice exercise though. Haven't done something like this in Excel since my MBA oh so many years ago. I guess it would have been Lotus 1-2-3 in those days.

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Reply to
themightyatlast

Forgot to account for taxes on my last post. At a 40% marginal tax rate you would only accumulate 525 times your original investment. So it wouldn't be any fun at all.

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Reply to
themightyatlast

money-zine.com has a bond yield calculator that gives the yield at

32.7%.

-- Ron

Reply to
Ron Peterson

Interesting ... I get an after 20% tax real rate of return discounted at 3% inflation equal to about 7.4%.

Never really caught on about natural logarithms ... most girls found them boring ... I used a NPV formula.

Hope I'm not being obtuse here, but what I find most interesting about tracking into the unfamiliar land of bonds and yields is that the original investment of $5.45 turning into $25 is an unadjusted 4.8% return. Adjusted for 3% inflation, it would be a bit under 1.8% annualized. Given that the current yield on the bond after 20% tax is

26%, I would have expected much more than a real return of 7.4%, of which the 1.8% capital gain is a significant component. I never really understood why I didn't like bonds that much - the nominal yield stated decreases each year by the rate of inflation, eventually approaching zero, and the interest is subject to tax bracket creep. The principal declines as well, assuming par for par, so you get to a zero return even faster.

By comparison, an investment in stocks - according the Siegel's averages and so forth - has returned an equivalent percentage to the exceptional XGM. A company that regularly increases its dividend payout should keep the yield constant at least above the rate of inflation (saving wear and tear on the calculators), and regular increases in earnings provides the equivalent of continuous compounding.

Reply to
dapperdobbs

A Credit Default Swap is a kind of insurance policy against a bond defaulting. You make an up front payment and then an annual payment. If the bond defaults, the seller of the CDS makes you whole.

Today, to insure $1,000,000 of GMAC bonds, you need to pay $450,000 up front and $50,000 a year there after. The market thinks GM is toast.

See

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-- Doug

Reply to
Douglas Johnson

Bill, without even looking at your specific calculations...that's NOT correct because you're using a financial calculation that applies to less-risky issues - a $25 trust-preferred selling for $24.33, perhaps.

You have to throw that out the window when you look at the debt of highly distressed companies - no doubt you're aware of GM/GMAC's issues, it's front-page news. Their debt is NOT being priced based on the model you're using, with 32.5 years of cash flows and a lump sum at the end. Rather, those distressed prices signal the market's belief that there is a very high risk of bankruptcy, suspended debt payments, restructuring, etc. It's a highly speculative guess about what the current debt holders might receive when the dust settles (which could be 32.5 years of interest plus principal at maturity, but the pricing says that is extremely unlikely).

I think this is a terrible place to head on your first foray into bonds!

-Tad

Reply to
Tad Borek

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