You are at a flea market on a muggy Saturday afternoon in August when you come across a non-descript vendor under a small green tent, The Small Box Store. A gentleman sporting a grey business suit mans the booth.
Once you are directly in front of his showcase, he greets you by delicately pulling back a beige sheet revealing three wooden boxes, about ten inches square, painted flat dark brown, unvarnished, and labeled respectively A, B, and C. You quickly see that the quality of the construction of box A is far superior to that of Box B, which in turn is better than box C. Each box also has a curious-looking analog calendar on the front.
Despite the obvious disparities in workmanship, each box is priced at exactly the same price: $100. Strange.
You ask: "What on earth are these for?"
He simply responds: "Watch this," not quite containing his enthusiasm.
He attaches a crank to the side of box A and begins to wind the handle. As he does so, the calendar manually advances one month at a time. When the calendar hits the six-month mark, the box suddenly bursts open and a puppet -- the very twin of this man -- pops out, startling you. The puppet's hand is outstretched toward you with $2 in it. Nice trick.
He repeats the stunt with the slightly dilapidated box B, but this time the puppet-in-the-box hands you $3.
He does it again with the still rougher box C. This time the puppet hands you $4.
"You see," says the salesman - genuinely excited now -- "If the box breaks, the payments stop altogether. The makers of the poorly constructed box have to pay you more in order for you to suffer that risk. Otherwise we would all choose box A."
His voice is bubbly now. He is excitedly rocking back and forth. You wonder if he might need to use the facilities.
"So," you ask, ready to walk away from the mildly amusing demonstration, "is... that it?"
"Oh no sir, that is most definitely NOT it! This is just a tiny sample. Would you like to see more?"
Without waiting for your reply, he turns around and pulls back a curtain revealing a vast warehouse filled with thousands of brown boxes. You poke your head back outside the tent, and wipe your eyes. The structure is only about 15 feet square, yet inside it somehow stretches on for what appears to be several acres.
Inside the deceptively cavernous tent, hundreds of workers are busy building thousands more boxes. Some of them are labeled AAA, some AA and so on, all the way down to C. Payment variations follow the same pattern as in his earlier samples. The better the quality, the more reliable and the smaller the payments. The poorer the quality, the less reliable and larger the payments.
The salesman explains further: "Anything labeled BBB or better is considered 'investment grade.' This means that they are reliable enough for discerning customers. Anything labeled BB or lower variously referred to as either 'junk' or the more pleasant-sounding 'high yield box.'"
Gazing around the tent, you see something hanging from the top of the circus-like tent. It is a large neon sign reading: "AAA rate: 2%."
Noting your curiosity, your host explains that this electric sign displays the payment rate for the iconic "best of all brown boxes," the AAA box. Every other brown box is geared to have its puppet pay in relation to the rate paid by the AAA puppet. The AAs pay a little more than AAAs. The As more still, and so on.
"Interesting," you lie. "Can I go now?"
"You can go any time you like, but I think you might want to see this."
Just then the AAA sign starts to vibrate violently. Smoke leaches out of the sides and the lighted digits on the unit flicker, first brightly, then off, then more brightly again, until the sign squawks loudly, sparks fly every which way, and smoke obscures the entire tent top. When the commotion stops, the smoke fades around the sign, which now reads: "AAA rate: 3 per cent."
The collective gasp from the hundreds of workers inside the tent is makes the event's significance unmistakable and they quickly make adjustments to the boxes they were working on.
You surmise that this rate change is somehow important, but your understanding is still fuzzy: "Something happened," you deadpan.
"Yes my little master of understatement. Something happened! Every new brown box from this moment forward must now adjust their six-month payment higher, in step with the AAA. If AAA is paying 3 per cent, then AA will have to pay maybe 4 per cent and so on."
At this moment a realization hits you.
So you ask: "If all the new boxes from this day forward will be spitting out more money than the old pay scale, what happens to the old boxes? Do they change their payouts to match? Otherwise nobody will want them, right?"
"No. Their payouts can't be changed," declares the grey-suited one. "But they will have to be sold at a discount. Instead of $100, they might sell for $95. It depends on the box quality, and market forces."
If you haven't already guessed, this story isn't about boxes but an oversimplified look at bonds and what happens to them when the US T-bill yield migrates upward. Decidedly unsexy, the bond market is nevertheless magnificent, and huge. Understanding it is crucial to understanding financial markets.
Mark Ryan is an advisor in Prince George with RBC Wealth Management, Dominion Securities, and can be reached at [email protected].
