We have warned against the extreme volatility in long bonds from just a slight up-tick in rates. Read here, here and here. In 2012 I explained the concept of duration writing: “wait until interest rates go up. The word to remember is duration. A bond’s duration is an approximation of the percentage decline in its value for every 1% increase in interest rates. The smaller the duration, the less sensitive a bond is, and therefore the less risky in terms of interest rate fluctuations. If rates increase by 1%, the price of a bond with a duration of 10 will fall by about 10%.” Here from The Wall Street Journal you get a illustration of what we’re talking about:
Desperate for yield, investors are buying government bonds that come due further and further in the future. If you lend your money to the government, you expect to get it back. It’s not for nothing that British government bonds are ‘gilt-edged,’ and the U.S. Treasury yield is considered ‘risk-free’ in financial models. What could possibly go wrong?
Unfortunately, a lot. A small move in the yield on these increasingly popular 40-, 50- and sometimes even 100-year bonds can have a crippling effect on their capital value.
Anyone who might sell before they mature (hint: that’s everyone alive today for the longest-dated bonds), should consider how they’d feel if their supposedly safe bond had lost a quarter of its value in two months. It happened to the rock-solid German 30-year bund, just last year.
This calculator lets you play with interest rates and see just how big an impact changes to yield can have on the price of long-dated bonds. You might be surprised by how big the losses could be, if the drops in yield of the past couple of years go into reverse.
Check out the Journal’s calculator here for more.
Latest posts by E.J. Smith (see all)
- A Risky Addition to an Otherwise Decent Dodd-Frank Reform: Part II - May 25, 2018
- A Risky Addition to an Otherwise Decent Dodd-Frank Reform - May 24, 2018
- A Warning for the Global Economy - May 23, 2018