Tuesday, February 5, 2013

Stay in Money Market or Go Out Slightly on Curve?

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.

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