Dr. P.V. Viswanath

pviswanath@pace.edu

A Calmer Market? Not for Long Bonds

November 13, 2010 New York Times

AN implicit goal of the Federal Reserve’s plan to buy $600 billion in Treasury debt is to stabilize the market. But this unconventional plan may mean even greater uncertainty for at least one group of investors: those who own long-term government bonds.

“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.

While the Fed has made it clear that it aims to keep intermediate interest rates very low by buying Treasuries maturing in the 5-to-10-year range, it has said little of its intentions for 30-year debt. As a result, investors who think that the Fed’s plan — called quantitative easing, or QE2 — could lead to higher inflation have managed to drive up long-term yields by selling 30-year Treasuries. Bond yields move in the opposite direction of prices.

Since late August, when the bond market first began to anticipate QE2, yields on 30-year Treasuries have climbed to 4.28 percent from 3.53 percent, leading to significant losses for investors who’ve been betting on long-term bonds. 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.

Of course, investors in long-term Treasuries have grown accustomed to stock-like swings in their holdings. 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.

The bond market’s reaction to QE2 is somewhat reminiscent of its response to the Fed’s announcement of its first round of quantitative easing, in March 2009, during one of the rougher periods of the global credit crisis, said Thomas D. Carney, a portfolio manager for the Weitz Funds in Omaha.

In that time, Mr. Carney said, “the Fed accomplished its intended goal of calming the financial markets.” But contrary to what some people believed could happen to Treasuries, he said, volatility grew. Yields jumped after investors grew more confident that economic recovery was near.

Indeed, within a year of that announcement, yields on 30-year Treasuries shot up to 4.75 percent from 3.6 percent. That helps explain why the average long-term government bond fund sank nearly 19 percent last year.

This time around, fixed-income investors could be at even greater risk of suffering losses, because they don’t enjoy that much of a “yield cushion,” said Mr. Davis at Vanguard.

What does he mean by that? Several factors determine how sensitive a bond may be to swings in interest rates. First, there’s duration, a statistical measure expressed in years, that tells how much a bond’s price would fall if interest rates climbed by one percentage point. If a bond’s duration is four years, for example, that implies that the price of the investment could fall 4 percent if interest rates rose by a full percentage point. But if that same bond yielded, say, 5 percent, investors could still avoid losses on a total return basis even if rates rose by a point.

Three years ago, a typical total bond market index fund was yielding around 5 percent with an average duration of about four and a half years. Today, that same fund has a similar four-and-a-half year duration, yet is yielding only around 3.4 percent. That means investors could wind up losing more if rates spike.

OF course, investors could be facing wide swings in Treasury prices whether rates go up or down.

For example, if the Fed succeeds in bolstering investor confidence and economic activity, long-term investors are likely to continue to sell 30-year Treasuries, leading to even greater losses on long-term bonds.

And if the economy heats up to the point where many investors fear the potential for inflation, something else could happen: Yields on 10-year Treasury notes and other intermediate-term securities could also start rising as investors move into more growth-oriented asset classes and as the Fed begins to curtail its bond purchases.

If, on the other hand, QE2 doesn’t spur as much economic growth as the Fed hopes, long-term bond investors might stop fixating on inflation and start to worry about another economic downturn — as they did earlier this year when the European debt crisis struck. Back then, interest rates reversed course quickly, sinking as investors sought the perceived safety of long-term Treasuries. Those lower rates meant higher prices.

The Fed’s powers are limited, said Carl P. Kaufman, co-manager of the Osterweis Strategic Income fund.

“In the long run,” Mr. Kaufman said, “economic results — not the Fed — will determine where long-term rates are going to be headed.”

Paul J. Lim is a senior editor at Money magazine. E-mail: fund@nytimes.com

Questions:

1. Why should quantitative easing lead to higher inflation? And why should it affect long-term rates more than medium-term rates?
2. OK, long-term rates are going up because of expected higher inflation. But why should the volatility of long-term rates increase?
3. Duration measures risk? How's that?
4. And if it measures risk, why is it called duration?
5. "..if the Fed succeeds in bolstering investor confidence and economic activity, long-term investors are likely to continue to sell 30-year Treasuries, leading to even greater losses on long-term bonds." Why's that?
6. “In the long run,” Mr. Kaufman said, “economic results — not the Fed — will determine where long-term rates are going to be headed.” So what does that mean?