Bond Math

By: Fred Sheehan | Tue, Jan 15, 2013
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This is the year for stocks. So one would gather from the media. The Wall Street Journal offered a lukewarm endorsement on Monday, January 15, 2012, with the headline: "Investors Flock to Stocks - So Far."

The diffident prediction opens: "As 2013 gets underway, one of the biggest questions in financial markets is again bubbling: Will this be the year that investors dump bonds and return to stocks?" The question may have surprised some readers. The S&P 500 has risen 120%, or, at a 21 percent-a-year pace since March 2009. How did stock prices more than double since investors have dumped stocks and bought bonds? A second question: what might we expect of stock market returns if investors stop taking money out of the market and put it in - 40% a year?

In fact, the Wall Street Journal is on solid ground regarding flows between stocks and bonds. A more important question than the one posed, is how did stocks perform so well when they have been so relentlessly sold?

Fruitful as such a discussion may be, that is not the topic here. It is such an important question, though, that the investor returning to stocks should study this paradox before jumping in.

Today, two subjects are addressed. First, the loss of principle lying in wait for bondholders is underappreciated, but stocks will probably do worse.

The Journal mentions "a quirk of bond math" by which "losses are exaggerated when yields are low." This sounds as if bonds are planning a sneak attack, but mathematics has no opinion.

To see why rising bond yields at today's rates is of such importance, we will look at changes in bond prices at different yields. In 1981, when the peak yield on the (20-year) long bond at auction was 15.81%, further deterioration to 16.81% would have reduced the price from $100 (par) to $94.10. Today, the (30-year) long bond that matures on November 15, 2042 comes with a 2.75% coupon payment. It is trading at around 3.00%. This one-quarter percent change causes a similar loss of income to bonds that had sold off by one percent in 1981. If the 2042's were bought at $100, investors would be holding a 5% loss on principle now. (The bonds would be trading at $95.09). When the 2042's trade at a 4% yield, the price will fall to $78.34. At 5%, the loss will equate to a $35% loss ($65.31).

These are not unlikely scenarios. Humanity needs higher rates; "when" is the quadrillion question. Then too, where will the money come from if "investors dump bonds and return to stocks"? New World Records of issuance were set or approached in several bond categories last year. If the flows gobbling up CCC corporates and State of Illinois general-obligation, pension-funding bonds take a deep breath, they may decide a current yield of 4.00% (on the latter) is crazier than buying Webvan at its peak. The first wave may buy stocks but investors who miss the bond peak will be shifting much depleted funds.

The stock market will look unappealing, though. Any significant rise in yield will probably cause greater losses in stocks than in bonds. Historically there is much evidence of this but more important than precedent is the reason the stock market trades 120% higher than four years ago. We must acknowledge the bizarre belief that central banks can prevent markets from falling. They will, at an undisclosed date, lose control of the Treasury market. In fact, they lost control a long time ago. Their bond-buying sprees are at least partially motivated by the knowledge that the Fed is the last dependable buyer of Treasuries. Bernanke is poised over an air shaft.

 


Frederick Sheehan writes a blog at www.aucontrarian.com

 


 

Fred Sheehan

Author: Fred Sheehan

Frederick J. Sheehan Jr.
aucontrarian.com

Frederick J. Sheehan

Frederick J. Sheehan Jr. is an investor, investment advisor, writer, and public speaker. He is currently working on a book about Ben Bernanke.

He is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and co-author, with William A. Fleckenstein, of Greenspan's Bubbles: The Age of Ignorance at the Federal Reserve (McGraw-Hill, 2008). He writes regularly for Marc Faber's "The Gloom, Boom & Doom Report."

Sheehan serves as an advisor to investment firms and endowments. He is the former Director of Asset Allocation Services at John Hancock Financial Services where he set investment policy and asset allocation for institutional pension plans. For more than a decade, Sheehan wrote the monthly "Market Outlook" and quarterly "Market Review" for John Hancock clients.

Sheehan earned an MBA from Columbia Business School and a BS from the U.S. Naval Academy. He is a Chartered Financial Analyst.

Copyright © 2007-2014 Frederick J. Sheehan Jr.

 

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