The most common question we are getting from the media right now has to do with "bonds getting slaughtered" and "do you think we are in a bond bubble?"
The answer to the first question is "which bonds?"
The answer to the second question is "yes."
Let's take a look at staying in money market (currently earning about 2/10ths of 1%) versus buying a 10 year bond. If we were to buy a 10 year bond (say GE 5% due 7/15/23) at 3.50%, what would happen if we have a yield curve rise (interest rate rise) of 1% over the next 24 months? How do we look 24 months from now if we have a parallel shift in the yield curve 100 basis points higher?
Well, rolldown is currently worth 22 basis points a year, meaning in 2015, we'd be looking at 3.50% rolling down to 3.06%. However, add in a 100 basis point rise in rates and voila, we are at 4.06%. In this scenario, our bond has fallen 3.78% in amortized principal value while the client has picked up 7% (3 1/2% x 2 years to make it simple) in yield.
The net gain or loss to the client is a gain of 3.22%. The person sitting in money funds has gotten 4/10ths of 1%...perhaps as much as 1.40% if they captured the move in the funds rate.
At some point, it makes sense to hide out in money funds, but in a steep yield curve environment, it more often than not makes sense to buy the 7-12 year part of the curve.
The difference of a 1% or 2% return may not sound like much, but when you are looking at a portfolio of $2mm, you are talking about anywhere from $20,000 to $40,000 difference in value.
We urge everyone to quantify their bond exposure and not fall prey to the media's hype.