“There could be near-equity-like volatility” coming for these bonds, warned Joseph H. Davis, chief economist and head of the investment strategy group at the Vanguard Group.and,
The Vanguard Long-Term Treasury fund, for example, has lost around 8 percent of its value in just the last two and a half months
In the first six months of 2009, the average long-term government bond fund lost 23 percent of its value, only to climb around 14 percent in the subsequent four months, slump 8 percent in the next six months, and soar 26 percent between April and August of this year.I applaud Mr. Lim for his mention of duration in the article, it's nice to see a journalist not treating his/her readers like idiots, but I wish he would have gone the extra mile and mentioned convexity. By bringing down long-term yields, the Fed was the one that increased volatility in bond prices by increasing duration. Just like the decline in long-term yields has created great gains for bond holders, it is putting them at great risk. To see why, look at the graph below.
|Image borrowed from thismatter.com
As you can see, the line turns nearly vertical as yields approach zero. This is the same effect that you see in the graphs displayed in the housing affordability posts. The slope of that line is the sensitivity of interest rates, in fact, the slope of the tangent is the duration that Mr Lim mentions. What I wish he had mentioned, however, was that that volatility is natural at rates this low. Changes in yield have not really been violent, but these instruments are very sensitive to yield levels. in the future, it will not be ticks up in yield that are at fault for making bond investors lose money, it will be the Fed for bringing down far rates to such low levels, and investors for not doing their homework.
Of course, investors need not lose money even if yields move up. Mr. Lim accurately explained how coupon payments may make-up for loss in bond price, but he forgot one more thing, the yield curve. With a positively-sloped yield curve, the value of a bond naturally increases as time passes because the rate on near-term securities is lower than those on longer-term securities. In other words, if the 30-yr rate is 6% and the 20-yr rate is 5%, then an investor could absorb a 1% rise in the 20-yr rate over 10 years without having to absorb a loss on the price of his/her bonds. This may do little for investors in the 30-yr bond, but when you consider the gap between the 3 and 7 is 126bp, you see how that positive slope can provide a little cushion to bond holders. In the mean time, though, investors looking for low volatility are cordially invited to invest in one of the safest assets out there, cash and cash equivalents.