The secret life of bonds — Part 1

Shortly after I started business school in the mid-1980s, I found myself surrounded by a group of people I never before knew existed — bond people. They spoke an arcane language, pondered the mysteries of monetary policy and worshipped an Apollo-like being named Paul Volcker. I was mesmerized and soon I too became an acolyte of the yield curve.

While others in my class were focused on banal topics like stock prices, corporate earnings and initial public offerings, I delved into the subtle nuances of Treasury bonds. It was a slippery slope, however — an onramp drug, as it were — and before long I was strung out on the newly emerging world of fixed income derivatives.

I read everything I could find on Treasury futures and options, most of it in academic papers I could barely understand. Treasury derivatives led me to mortgage-backed securities and then derivatives on mortgagebacked securities with their quirky embedded options. From there I started experimenting with collateralized mortgage obligations, or CMOs, where dealers would pool together thousands of mortgage-backed securities and then slice and dice them into tranches that each had its own unique risk and return characteristics.

Early one morning, after a long night spent building a model to price mortgage-backed securities, I looked at myself in the mirror. A pale visage stared back at me, dark bags sagging under bloodshot eyes. Yet, despite my haggard appearance, I felt a deep rush of exhilaration. It was then that it hit me, I had become a total bond junkie. I spent the next 12 years of my life exploring in great detail the world of fixed income. My portfolio management responsibilities ranged from U.S. Treasury bonds to junk bonds and from mortgage-backed securities to emerging market debt. I loved it.

Some people have the idea that bonds are boring, low-yielding and safe. Certainly, this is true for certain sectors of the bond market. However, other sectors, like high yield bonds, can experience volatility very much like stocks. Even “super safe” Treasury bonds can expose investors to horrific losses when held in the wrong kind of environment. Given current economic trends, we may be entering exactly the wrong kind of environment for bonds.

Bond prices are driven by changes in interest rates. When interest rates fall, bond prices go up; when interest rates go up, bond prices fall. The sensitivity of a bond’s price to a 1 percent change in interest rates is given by something called the bond’s modified duration. Modified duration is stated in years. Generally, the longer a bond’s maturity, the longer will be its duration. For example, the modified duration of a 2-year bond is currently just less than 2 years, while the modified duration of a 10-year bond is currently about 9 years. This means that a two-year bond will lose 2 percent of value and a 10year bond will lose 9 percent for a 1 percent rise in interest rates.

With this in mind, think about the interest rate environment of the past 40 years. In October of 1981, the yield on 10-year Treasury bonds peaked at its all-time high of 15.68 percent. By August of last year, it had fallen to its alltime low of 0.54 percent. In other words, interest rates fell by more than 15 percentage points and bond prices soared during a 40-year bull market. No wonder some people think bonds are safe and boring. They have never experienced a protracted period of rising interest rates. But the world may be changing.

Since last August, the 10-year Treasury yield has been rising. It now stands at 1.66 percent. Based on its modified duration, we know that anyone holding a 10-year Treasury has suffered a loss of nearly 10 percent over the past eight months. If rates continue to rise, those losses will increase.

As we face the possibility of a rising rate environment, bond investors should give careful thought to their bond strategy. Over the next couple of weeks, I will discuss a few simple portfolio strategies for dealing with rising interest rates. Along the way, I will introduce you to additional key concepts about the bond market. Who knows, maybe some of you will catch the bond market bug, too.

Next week: Immunization, laddered portfolios, and compound returns.

I read everything I could find on Treasury futures and options, most of it in academic papers I could barely understand.

Steven C. Merrell is a partner at Monterey Private Wealth Inc., an independent wealth management firm in Monterey. He welcomes questions you may have concerning investments, taxes, retirement or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to smerrell@montereypw. com.