What Bonds Indicate to Forensic Accountants
We're going to talk about the fixed income market here. And bonds are, a lot of people get confused by bonds, because you have to think what a bond is. A bond is basically a piece of paper, and on it says $1,000, and it gives you an interest rate. So let's say it says, $1,000 and they're going to give you 5% for 5 years or 2 years. So you're going to get $50 every year for the amount of years on, and there is a piece of paper.
But what happens is, interest rates fluctuate, okay? So, even though this bond says 5%, the market rate may go up past 5% or down. Because when the bond was issued 5% was a fair rate, but it's changing all the time. So if the market rate goes up, the $1,000 on the bond goes down, it's inversely related. Think about it, yeah, I know it's a little bit complicated, but it's the interest rate, there's one on the bond and there's an effective rate.
The effective rate is what changes the price of the bond. And the reason this is so important is because millions and millions of people buy bonds, and because they buy bonds, we have something called the wisdom of the crowds. You can read what's going on in the economy. For example, what I do is, I look at the 2-year bond and I look at the 2-year- the 10-year bond, okay. Right now, the yield on the 2-year bond is 1.8%, and the yield on the 10-year bond is 2.4%.
And those yields they're pretty close, there's 60 basis points between, and that is signaling depression or recession is coming. There's a strong correlation when these bonds, what they call flattening of the yield curve, when a 10-year bond is lower than a 2-year bond. Think about it, why would you want to have a 10-year bond paying less than a 2-year bond? Because you think that in the following years there's going to be a depression or a recession, the only thing, and these people who are buying...
Generally, I think people who are buying bonds are a lot smarter than people who are buying other stuff. So these smart people are signaling, as this rate comes down, depression, recession. And this has been, like I said, if you go back 100 years or 200 years, there's a strong correlation. But remember, correlation is thought the same as causation. And maybe this time it's different because interest rates are so low.
This is really a big topic among economics and among forensic accountants, because we use these rates when we do value businesses, and also, this helps us predict what's going to happen in the future, which obviously is very important when we're valuing businesses. So, it's worth your while to get into and understand how the fixed income market works, and especially to track these 2 and 10-year bonds. Because if this yield inverts, there could be big, big problems. Like I said, there's only 60 basis points, and the 2-year is going up, and the 10-year is coming down. And once they invert, once the interest rate, the yield on a 10-year bond is below the yield of the 2, it could be a very big issue. If you have any questions on this, feel free to give me an email.