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Msg  2014 of 5069  at  1/22/2011 11:29:20 AM  by


Tom Graff - Bond Life

I thought this was informative.............................Xot
 From Realmoney 1/21/11 by Tom Graff
Bondlife: Rising-Rate Roulette

By Tom Graff
RealMoney Contributor

1/21/2011 5:00 PM EST
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Interest rates are very likely to rise over the next year or two. To what degree, how quickly and when that rise in rates might begin is hard to say. But the economy does seem to be firming, the Fed is not likely to do another round of asset purchases, and inflationary pressures may be building. This has led many investors to hold unusual amounts of cash. It has also spurred interest in products such as the ProShares UltraShort 20 Year-Plus Treasury (TBT - commentary - Trade Now), which each month breaks new records for shares outstanding.
But how risky are bonds really? What are the odds that a typical diverse bond portfolio will produce steep losses? Instead of jumping to conclusions, let's put pencil to paper (or perhaps more accurately, typeface to bandwidth) and do the math. In this week's Bondlife, we'll take a real bond portfolio and put it through the rising-rate wringer, and see what comes out the other end. Our conclusions will be very different depending on what kind of investor you are.

Plus, why you should buy high coupons in some markets and low coupons in others, and should states be allowed to declare bankruptcy Get ready to spin the wheel, Monte Carlo style!

Interest Rates and the Fed: Roulette

Bond portfolios are more complicated that you realize, and the risk/reward cannot be summarized as merely duration vs. yield. To illustrate what I mean, I did a Monte Carlo simulation. I ran the simulation over eight quarters, with each quarter having its own independent simulation run. In each case, the simulation assumed that all rates would move parallel and that the rate shifts were normally distributed. The standard deviation was assumed to be equal to the 20-year average for 10-year bonds, and the mean of the rate distribution was set at +25 basis points. So therefore, on the basis of this simulation, if all eight quarters were exactly equal to the mean rate shift, then all rates would rise by 200 basis points over the course of the two-year simulation.

I assumed a portfolio which was evenly invested between one-to-10-year maturities and that the whole portfolio has an average yield spread of 80 basis points over Treasuries. This is equal to the yield spread on the taxable bond fund which our firm manages. I then assumed the portfolio remained static over the two years, except that all income and maturities were reinvested in a new 10-year bond. While this model employs a bit of a simplification, it's a pretty good proxy for a real portfolio managed in a real way.

The quarterly Monte Carlo analysis produces results that are much closer to reality than a simple stress test of a portfolio with a +200-basis-point shock. The market will not suddenly shift 200 basis points; instead it will oscillate back and forth, potentially winding up +200 basis points but following a mixed path along the way. It could be that it rises 300 basis points and then takes 100 basis points back. Or it could rally 50 basis points before selling off 250 basis points. Each of these scenarios creates a very different reinvestment opportunity. Running a series of Monte Carlo simulations (I ran 1,000) gives us the chance to see how this portfolio might perform in a variety of paths.

The chart below shows the distribution of final 10-year Treasury rates based on the simulation. The rate is along the bottom, and the percentage of simulations that ended with a rate in that range is along the vertical axis.

Not surprisingly, only about 4% of scenarios wind up with interest rates materially lower than today, and 70% of scenarios result in yields in the 5% to 7% range, which is consistent with around +100 to +300 from where we are now. Stop here for a moment. If you knew this was the potential distribution of 10-year interest rates between now and the end of 2012, you'd be ready to short bonds right? Or at least hold cash.

Yet there are a lot of things going for bonds that tend to severely dampen the volatility of a portfolio. Look at the distribution of total returns produced by the simulation.

Only about 13% of scenarios produced returns at or below zero. This essentially tells you that in all but a small percentage of cases, an investor would be better off holding the one-to-10-year bond portfolio than holding cash. How can this be with most of the rate cases resulting in substantially higher rates?

Bear in mind the following: First, the cash flow is getting reinvested. Einstein allegedly said that compound interest is the most powerful force in the universe. Well, the compounding factor actually improves when rates rise, because the reinvestment happens at higher rates. Second, when a bond drops in value, its accretion factor improves. That is, as time passes, every bond price moves toward par. This isn't some kind of accounting magic, it really is how bonds trade. If you own a 10-year bond at $100 and market forces cause it to drop to $90, that $10 discount to its maturity value gets amortized over the life of the bond. So if nothing happens, in one year, the bond is worth $91. In two years it is $92. Another way to think about it is if you start with a bond with a coupon of 3.5% and market yields rise such that it now yields 5%, even though you have a capital loss on your initial 3.5% position, looking forward the bond does indeed yield 5%. Since your original 3.5% coupon is less than the market yield, the difference is made up through the accretion of the discount.

Finally, as bonds get shorter, the yield the market demands naturally declines. For example, five-year Treasuries currently yield 2.05%, whereas four-year bonds yield 1.53% and three-year bonds yield 1.06%. That means that if nothing changed about the curve slope but yields rose 100 basis points across the board over two years, five-year bonds would rise from 2.05% to 3.05%, but one who actually bought a five-year bond two years ago would now own a three-year bond. Under our scenario, three-year bonds would yield 2.06%, so the two-year-old five-year bond would basically be unchanged in price.

 What are our conclusions here? First, bonds are more resilient against losses than you might think, especially if you give them a little time for income to accrue and time to be on your side. As a corollary, this tells you that if you are holding bonds because you want a relatively stable portion of a larger portfolio, then this standard bond portfolio fits the bill. Second, holding cash becomes very timing dependent. Sure, if yields rise in the very near term, it can work for you. But unless you have that very specific outlook, you will probably do better owning an intermediate-term bond portfolio.

That being said, there remains very little upside opportunity in bonds. We are remaining very tactical in our positioning, trying to make a lot of small winning trades rather than making big macro calls. We believe this can add enough alpha to make bonds reasonably attractive, but the fact remains that bonds are what they are: fairly stable, but lacking upside.

Treasury Bonds: Getting Nothing From Something

What about shorting Treasuries? As with cash, this becomes very much a timing game. In my Monte Carlo analysis, 83% of scenarios resulted in rates rising by at least 1% by the end of two years, and 41% of scenarios saw rates rise by at least 100 basis points in a single quarter at some point during the simulation. Clearly, if you are good enough to time that move correctly, there is good money to be made shorting Treasuries. But if your timing isn't right, your results can become very pedestrian very quickly. The curve roll-down, the discount accretion and the income compounding are all working against you. A Treasury short should be a trade you make when interest rates look like they are going to imminently rise. It's not a trade you just hang on to.

Corporates and MBS: Luck Only Lends

In a rising rate environment, you want to own high-coupon corporates and low-coupon mortgage-backed securities. High-coupon corporate bonds pay you more money during the life of the bond, and this gives you better re-investment possibilities as rates rise. Low-coupon bonds pay you more at maturity, so you have fewer reinvestment possibilities in the near term.

The opposite is true of MBS. High-coupon MBS have less natural principal retirement (because more of the monthly mortgage payment is going to interest). Plus you have to pay up for the high coupon, but you don't know if the mortgage holder is going to prepay. So you could be paying up for a high coupon which you'll never actually get. Low-coupon MBS have much more stable average life profiles, meaning you know what you are getting and will have a steady stream of principal payments to reinvest at potentially higher rates. This is especially true if you buy a shorter amortizing bond, such as a 15-year MBS. This kind of trade really takes advantage of the compounding described above.

Municipals: Living Dangerously

Should states be allowed to declare bankruptcy? Several articles are suggesting that Congress is giving it some thought, most recently in a New York Times piece from Friday. I think there is a lot of logic to this. It was only after declaring bankruptcy that the airlines and the auto companies were finally able to strip out badly structured retirement benefits and modernize their business models. I'm not certain that every state can make the cuts needed in their pension benefits without a court forcing the unions to the table.

But one thing should be clear: No state has a "debt problem" per se. It isn't debt service payments or even the need to roll over any given debt that is crushing certain states. In fact, states have a budget problem, which in my opinion is inherently a political problem, not an economic problem. In fact, I'd argue that only a handful of states have a serious pension/benefit problem, and maybe only Illinois really needs bankruptcy. Maybe just the threat of such a thing is enough to bring the unions to the table.

All this talk makes me all the more cautious on buying Illinois bonds. I mentioned a couple of weeks ago that one could consider the Illinois 5.1% bonds due in 2033, which are taxable bonds and trade regularly. These bonds have been trading around $75, which gives you a lot of protection in the event Illinois winds up trying to settle its debt for less than $100. If you consider Illinois at all, please don't make the classic mistake of buying short-term debt (which inevitably is trading near par), figuring this will protect you. If the worst happens, all debt will get the same haircut. Buy the lowest dollar price bond you can.

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