Bond Investment and Rising Interest Rates

US10yr4

Some time ago I took the annual coupon of the US 10 year Treasury Bond going back to 1927 investigated the effect on a bond index of rising interest rates.  I created a total return index based on constant maturity which is about as good as you can get given the lack of public figures (if they even exist) on bond funds going back that far.

Much alarm has been raised in financial circles and the blogosphere on how bond investors will fare in a rising rate environment, with particular and (largely unjustified?) concern surrounding risk parity funds such as Bridgewater and AQR.

I have no idea how or the extent to which they gear up their bond investments so that the volatility on bonds equals that on stocks. If they use the long bond, I assume they use little to no gearing. I do not imagine they would be able to gain much by gearing up fed funds or the Eurodollar – you can only gear a coupon by borrowing cheap to invest in a lesser credit or at a longer maturity if the interest rate curve slopes upwards.

Nonetheless an index of the 10 year is instructive in showing that widespread panic and gloom is probably unnecessary, unless we were to face a rapid and very steep increase in rates. A swift 1% hike in rates for the ten year would make for a painful 8% drawdown, which would take a while to recover from.

Interest rates rose throughout the period 1949 to 1981. You can see that the cumulative drawdown in price amounted to around 60% in the period. Very painful you might think. But this is to ignore the fact that fund managers would be re-investing as they went along into higher coupon bonds which helps to make up for the price action.

You can see from the drawdown chart of the total return series that drawdown during the period of rising rates was not significant.

Yes, return was lower during the earlier period – CAGR of around 5% as opposed for the later period of close to 9%.  But the period 1949 to 1981 was clearly no disaster.

If there is one thing I have learnt over the years, it is that forecasting is close to useless. The future may not resemble the past. Rates may rise rapidly and steeply. But perhaps looking at history gives some comfort that bond investing over the next decade may not be too painful after all?

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