I used Gumby's excellent tutorial to buy my first batch of treasury bonds on Fidelity about a year ago but upon further reflection I have a question about the advice......
For the Permanent Portfolio, we don't care what the coupon is. We just want the longest Treasury bond we can find, because longer Treasuries are more powerful. We've found the longest Treasury available here at the bottom of our list, so let's buy it. Click on the "Trade" button next to that Treasury bond.
Can somebody explain the reasoning behind this? The example that Gumby shows displays a choice between bonds with a 4.625 coupon at the top and 3.75 at the bottom with maturity dates within about 18 months or so. He says take the one at the bottom. Why is that "more powerful" than the ones with higher coupon above it? Can anyone explain?
The primary driver for how much a bond changes in value with a given change in interest rates is how long the bond has until its maturity date. Longer bonds are more sensitive to interest rate changes than shorter bonds. The coupon rate doesn't end up mattering very much since all bonds are priced essentially as if they're paying whatever the current interest rate is. The way this works is a higher yielding bond will cost enough more than a lower yielding longer bond so that the effective interest rates will be about the same (for two bonds of the same remaining maturity). A longer bond is still longer, so it will move up and down more in response to interest rate changes than a shorter bond - regardless of the coupon rates of the two bonds.
It's because the lowest bond in that list has a higher Yield To Maturity, which is its price-adjusted yield, since bonds with higher coupon payments have greater value and will therefore cost you more to buy. If it's close, I like to buy the one with the higher coupon simple because the price you pay now is a sunk cost, while the greater interest payments are something you'll see for a long time. This is somehow more psychologically satisfying to me.
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Pointedstick wrote:
It's because the lowest bond in that list has a higher Yield To Maturity, which is its price-adjusted yield, since bonds with higher coupon payments have greater value and will therefore cost you more to buy. If it's close, I like to buy the one with the higher coupon simple because the price you pay now is a sunk cost, while the greater interest payments are something you'll see for a long time. This is somehow more psychologically satisfying to me.
Have you computed the dividend payments you'd actually receive buying a fixed dollar amount of different coupon (but similar maturity) bonds? I haven't, but my guess is you'd receive pretty close to the same amount in dividends due to the different amount of bonds a given amount of dollars would buy.
