3

"The situation with low-yielding debt has gotten so extreme that Fitch Ratings warned Tuesday that a simple normalization of yields to 2011 levels could cause investor losses of $3.8 trillion. The losses would come in the form of principal plunges, as prices fall when rates rise. The low-yielding debt is held almost exclusively by institutional investors, meaning it poses systemic risks."

source: http://www.cnbc.com/2016/08/02/investors-to-central-banks-we-arent-listening-anymore.html

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I can understand your confusion here. Normally when a borrower, such as a corporation or the government, borrows money by issuing a bond, the amount being borrowed is referred to as the principal. This amount never changes over the life of the bond. For example, if a corporation borrows $10,000,000 through a bond issue, then, from the corporations point of view, the principal amount remains fixed at $10,000,000 for the life of the bond. However, what the market is willing to pay to participate in the interest payable does change over the life of the bond.

In the example text you are quoting, the term principal is being used to refer to amount an investor has invested. The market value of an investment in bonds will change according to the prevailing interest rate environment and the perceived credit worthiness of the borrower. When interest rates go up, bond prices tend to go down. With current interest rates so low, an increase in interest rates to 2011 levels would mean a dramatic change in the interest rate environment and a corresponding dramatic effect on bond prices, resulting in a "plunge" in bond prices. The quoted text describes this as the "principal plunging".

2

It means that people have invested so heavily in low yielding debt, that if rates return to "normal" higher levels, people will take large losses on "principal" to compensate for this fact.

I'll use one year debt as an example. Lets say that 100 of debt yields 1% at today's low rates. At the end of 1 year, you will recent 1% interest, or 1, plus your principal of 100, for a total of 101. That's a low total because your 1% interest rate is so low.

Let's say that "overnight," the market rate of interest returns to its historical level or 2%. Then the 100 of 1% debt that you invested in is no longer worth 100, but a little over 99. That's because if you "discount the 101 you'll receive backwards by 2%, you'll get a figure close to 99, rather than 100.

In this example, the 1% overnight rise in interest rates cost you a "point" out of 100. And let's say that we're really talking about $100 million or $100 billion. Then the "1 point" loss would be $1 million or $1 billion, respectively. That would be your "principal plunge."

For a ten year note, the so-called "duration," (cash flow weighted average of the repayment times) would be about nine years (not much below ten). In this case, a 1% rise in interest rates would cause about a 9% (1% times duration of 9), decrease in the principal value of the note from 100 to 91.

  • +1, but I'd love to see you talk about the drop of say a 10yr note if the rate went to a more normal 4%. 100 to 99 just doesn't feel like a plunge. – JoeTaxpayer Aug 4 '16 at 0:38
  • @JoeTaxpayer: Added last paragraph, and used a simplified form of "duration" for the calculation. Thanks for your support. – Tom Au Aug 4 '16 at 1:27
  • That's it. And a 3% move is a 27% drop. That's a plunge! – JoeTaxpayer Aug 4 '16 at 1:52

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