A PRIMER

The man who wants to make an entirely reasonable will dies intestate.  

         George Bernard Shaw

Perhaps nowhere does Shaw’s dictum better apply than to markets. Markets never behave reasonably for very long. And they never will if for no other reason than all the players are human.

Yet that doesn’t excuse investors from acquiring some understanding of the whys and ways markets work. What you really need to know about and understand is 2Cs, 2Ps, 2Ls, 2Vs and one lonely little S. No, this isn’t some esoteric formula or pre-calculus math exercise. But if you can grasp this material you’ll be well on your way to avoiding many of those calculus-like shoals that infest the investing world. 

Let’s begin with the 2Cs, credit and correlation. Remember in Chapter One we discussed credit and the subject cropped up again in the chapter on bonds. The key to learning is repetition, repetition, repetition. We mentioned risk. It turns out that credit is somewhat Janus-faced—that is, a borrower may default, something market pundits call default event risk (Review chapter on risks!). That’s pretty simple. A borrower, for whatever reasons, decides to walk.

The other face of credit risk you need to understand more clearly because it involves that lonely little S mentioned above. But for now, here’s the answer: even with a loan where there is no defaulter, the lender incurs something called spread risk. And that’s what the little lonely S stands for, spread. The spread on the loan the lender makes may widen.

 We’ll say it again, SPREAD!  It turns out most things in life involve a spread of some kind. You purchase 100 shares of XZC Corporation stock. The shares are quoted at ask 23 ¼ and bid at 23 1/8. The ask 23 ¼ is what you must pay to buy the stock; the bid, 23 1/8 is what you can sell it for. So obviously, for you to break even or make a profit (commissions and all other costs aside), the stock has to appreciate in price above the asking price.

The difference then between the bid and the ask price is called the spread. Spreads in the stock market vary according to where the stocks are traded and according to market capitalization (Remember that term?). Usually larger stocks, large capitalization stocks, have smaller spreads, or bid and ask prices, than small cap stocks if for no other reason than small companies are viewed by the market as being more risky.

Remember risk involves costs; you have to pay up for risk. But make no mistake, spreads matter. Stocks traded on the New York Stock Exchange are usually older, larger companies, and as such have smaller spreads between the bid and ask prices than those traded on the Nasdaq.

There is a spread on the money your mortgage company lends you to purchase your house. They don’t lend you the money at their cost; they mark it up a bit; some say they mark it up a lot. In the bond market there is a spread between the yield on U.S. Treasury bonds and municipal bonds of comparable maturity. Like most things in life, that spread fluctuates.

Since most municipal bonds (Remember Chapter 2.) pay interest that is exempt from federal income taxes, you will hear from time to time, if you’re paying attention, investment gurus touting municipal bonds as being a good buy because they are paying or yielding 90 percent or so of comparable Treasury bonds.

Treasury bonds, recall, escape state but not federal income taxes. There is a spread between what AAA corporate bonds yield and, say, lower graded, also called junk bonds, yield. As interest rates come down that spread usually narrows. One reason is demand. People who depend on yield to live, many retirees for example, are forced to take more risk to get the income they need. So they move into lower qualities assets not so much by choice but by necessity.

The above is an excerpt from Up The I. V. Pole A Manual. 

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TWO SIDES

The trouble is they both can't be correct.

On one side are the strategists who think Bernanke will end the Fed's bond-buying spree sometime this September and that will push the 10-year Treasury note yield up to 2.5% by year end. Goldman Sachs, the Wall Street firm with a long lineage to the Fed, among others, falls in that camp.

In the other camp are those who feel the economy is still weak and the key rests with labor or jobs numbers. They also see stocks, given their strong run-up this year so far, as risky and believe that will provide a buying platform for bonds that keeps yields around 2% as investors try to hedge a market down turn.

As noted they can't both be correct.

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