The BIG Bernanke: Bond risk for the duration!

The infatuation of investors, retail and institutional alike with bonds has become ridiculous – more lust than love.

The perception that there remains less risk in fixed income cannot be further from reality – especially because of the post-crisis distortions imposed upon interest rates and the bond market by the US government and replicated around the globe.

Growing up in the 60’s and 70’s means you get used to occasional flashbacks. Here’s one every investor should take to heart (note the date):

(FORTUNE Magazine October 17 1994) – WASN’T THIS supposed to be the year Alan Greenspan got to triumphantly parade down Wall Street to the cheers of bondholders big and small? In many ways the circumstances seemed right. In January 1994, the 34th month of economic expansion, bond yields were historically low and inflation seemed negligible: Wages were going nowhere, and companies dared not raise prices. But within seven short months of that promising start, something fairly unusual happened: 1994 became the year of the worst bond market loss in history. Since the Federal Reserve began nudging short-term interest rates higher in early February, the bond market has inflicted heavy damage on financial companies, hedge funds, and bond mutual funds.

Long-term bond funds lost in the order of -7% in 1994 although funds with more laddered (short and long) maturities lost somewhat less. By the way, the S&P 500 didn’t lose any money that year even if its rate of return return was only a percent or so. This “worst bond market loss in history” was in fact bested a few years later in 1999 (closer to -9%).

The measure we call “duration” is most readily bandied about as the definitive measure of bond risk; it approximates the percentage change in a bond’s price for a 1% change in its yield to maturity (YTM). So, for instance, the price of a bond with a 10-year duration would change by 10% if the yield to maturity – NOT the coupon or monthly distribution – were to rise or fall by 1%. For practical purposes, the yield to maturity is what the market deems to be a fair rate of return on the bond given it’s term-to-maturity and cash distribution (coupon yield).  And what is deemed to be a ‘fair’ return by the market depends on the overall level of interest rates.

For kicks let’s use the duration of an actual Treasury Bond portfolio to play with. A 1% increase in yield should result in a 7.76% decline in the price or value of a $1000 investment. $1000 invested would now be worth $924.

This rough estimate we use, mathematically speaking, is only effective for very small changes in interest rates.

Consider what happened on one day last weak (Thursday Oct. 25th):

The U.S. 10-year yield rose five basis points, or 0.05 percentage point, to 1.84 percent at 9:53 a.m. New York time after reaching 1.85 percent, the highest since Sept. 17, according to Bloomberg Bond Trader prices. The 1.625 percent note maturing in August 2022 declined 15/32, or $4.69 per $1,000 face amount, to 98 2/32.

The duration of our 10-year U.S. Treasury bond portfolio is you will recall = 7.76. On that day rates increased .05 of 1%. So we shouldn’t be surprised if a $1000 investment in our portfolio dropped (very roughly) by .05 x 7.76 = .388% or $3.88 to become a $996 investment. Why the difference from the move in one US Treasury bond (see quote again)? Duration is only an estimate, and keep in mind the portfolio may hold bonds with higher coupons (cash distributions) which reduces its price sensitivity to interest rate changes. After all, a bird in the hand…..

What may come as a surprise to pension investment and endowment fund committees, and certainly your average investor dude, is what happens when interest rates rise from these extremely low levels by a more substantial 2%? Will your $1000 investment decline by (2 x 7.76) 15.52% to $844.80? The real answer is: Impossible to tell! This measure we call ‘duration’ is far less accurate for bigger interest rate changes, and a doubling of rates from current levels would be VERY big indeed. Investors are pretty much at the mercy of those demonic market forces.

The point of this tedious discussion is that fixed income (bonds) securities are not nearly as safe today as the consensus believes. Is there really less volatility – which some equate to riskiness – in bonds? Check the above quote again and note that the 10-year Treasury declined in price by .469% in one day. The following quote appeared on that very same day:

Concern about the outlook for company earnings has pushed down the S&P 500 3.9 percent from this year’s high on Sept. 14. The benchmark index has risen for the year on speculation central bankers will keep economies expanding.

The stock market took over a month to decline 3.9%. Generalizations about what is more or less risky are as dangerous and misleading as sweeping statements about race, sex or religious affiliations.

The Big Bernanke?

The FOMC will need to decide by the end of December whether to continue with Treasury purchases after the expiration that month of so-called Operation Twist. Under that program, the central bank swaps about $45 billion each month of short-term debt and buys the same amount of longer-term Treasuries. The Fed by the end of December will have largely exhausted its supply of short-term debt.

It’s anybody’s guess what happens to the level of interest rates once the ability, or the need of governments to keep the level of interest rates low wanes – as happened in 1994. It would be delightful if bonds did provide the safety that institutional and retail investors are expecting. Then fund flows like we saw last week might be justified:

• Bonds: Massive $9.4bn inflows = largest weekly inflows on record in absolute terms.
• Equities: $4.2bn outflows = 4 straight weeks of redemptions.
• Commodities: modest $0.6bn inflows.

Unfortunately that feeling of security is as much of a delusion as was the feeling of bliss experienced by ‘The Dude’ in the below clip from the film The Big Lebowski.

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