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How the Bond Markets React Not too many folks are aware of what a carry trade is. In its most simplified form, it is money borrowed at low rates that is then used to by securities (fixed income) at a higher rates. Several things need to be in perfect alignment for a good carry trade scenario to be worth the effort. That alignment is coming unhinged and the emerging bond markets are getting pummeled in the process.
Emerging markets and corporate bonds rely on a certain amount of carry trade to help finance their risk. Fed Chairman Greenspan has suggested that the pull back of growth proposed by China will negatively impact world commodity prices. That pull back will have additional ramifications that will ripple through world markets. The bonds sold by countries who are developing their growth around apron strings of the biggest players are suddenly faced with a withdrawal of buyers for their bonds.
Fortunately for the homeland credit market, the effects of a good jobs number, the specter of inflation and the weight of the deficit have not done what the did in 2002. But rates are going up, according Greenspan and although no one believes they will raise them in any fashion reminiscent of 1994 when the then current rate of 3.00% was pumped up to 6.00%, they will rise significantly.
In other news, the Treasury will add two additional Treasury Inflation Protected Securities or TIPS. Currently only a ten year note is available. The Treasury plans on adding a five- and twenty-year note as well. Earlier this year, Bill Gross suggested that he was interested in these types of notes and the price was promptly driven up making them less attractive. About $200 billion of investable dollars now sits in the 10 year offerings, a mere 1% of the total money at work for investors.
These bonds work like this: With any increase in the government's inflation indicator, the Consumer Price Index, the rate is passed on as an increase to the principal. Should you buy at a $1000 bond at 2.5%, and the CPI is reported at 2%, the value of the principal increases to $1,020. From here your interest is calculated every six months.
But it isn't all upside. TIPS generally offer a lower interest rate. The real gain due to inflation increases will not kick in until the rate reaches 2.5% or better. An un-tethered ten year note is hovering around the 4.75% mark and may go higher. A change in the inflation rate however won't change the coupon rate. But the increase in the principal is taxable even if you are unable to cash the gain out until the bond matures.
Use a mutual fund that invests in these types of bonds to get the most from this type of fund.
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