Wednesday, February 3, 2010

More on Yield Curves

OK, so this may be a somewhat technical (boring?) post but I think it may be of interest to bond investors.

As mentioned in previous notes, the shape of the yield curve in both the taxable and municipal bonds markets is quite steep right now. The question is: should you sell your shorter maturity bonds in favor of longer maturities?

For example, one year AA-rated municipal yields are a whopping 0.3%. Intuitively, to me, this makes little investment sense, unless one is expecting a quick spike in interest rates (which I am not, by the way).

Ah, you say, not so fast! What happens if interest rates rise*? Won't the market value of my bonds drop, and thereby wipe out any additional yield?

There are lots of ways to discuss this. In this post, I will look at the question this way:

If I have a 1 year time horizon, how much do yields have to rise before the concomitant principal decline wipes out any yield gain that I might derive from extending maturities?

Put another way: 1 year AA-rated municipal yields are currently 0.3%. If I buy a municipal with a 3 year maturity that yields 1%, how much do yields have to rise in 1 year before the 80 bp additional yield has been wiped out?

The answer: 60 bp.

In other words, if I buy a 3 year note today, and a year from now that note is yielding 1.3%, I would be indifferent (from a total return standpoint) between a money market and a 3-year note.

I played around with alot of numbers, and different scenarios, for bonds across the maturity spectrum. As it turns out, the largest total return advantage comes in extending from cash to the intermediate sector. For example, rates on 2015 paper would have to be 90 bp higher than today in order to be indifferent to simply sitting in cash.

One final note: this exercise assumes that I would actually be selling the longer paper a year from now. For many of my clients, they are more interested in the income, and are not so worried about "paper losses". Staying in cash if short rates stay low for a couple of years may be painful for investors who want to avoid using principal.

*Note: there is virtual unanimity among my clients that rates are going to rise.

** Usually when everyone agrees on something it doesn't happen