Bonds, Interest Rates, and Risk. Part II - What if Rates Rise?

My last post highlighted how interest rates rising, result in bond values falling and vice versa.  I also mentioned how duration provides an easy way to calculate this - how your bond portfolio’s value will rise and fall given a 1% move in interest rates.

Recently I wrote about how low Treasury yields are currently, and that I don’t think yields will rise for awhile.  This view was reinforced in comments  made by Janet Yellen, the Vice Chairwoman of the Federal Reserve, when she said rates could stay low through 2014.

Still, I could be wrong and rates could rise, which would result in the value of bonds falling. 

The next question is if interest rates do rise, by how will they go up?  I took a look at the 5 year Treasury note since 1953 comparing year-over-year changes on monthly data, using only periods where interest rates were rising.  I picked 5 years because the current modified duration on a 5 year Treasury Bond at with a coupon rate of 1.00% is about 4.85, which I think is a good risk/reward tradeoff between a steep yield curve and low absolute rates.   

Here is what the data show:

• Mean: 0.89

• Standard Deviation: 0.81

• Max: 5.26

In the next post of this series I will breakdown this data and explain what it means.  

Bonds, Interest Rates, and Risk. Part 1 - Bond Values and Interest Rates

As interest rates rise, bond values fall and vice versa.  Think if it this way, if I purchase a bond for $100 that pays 5% and interest rates rise to 6%, why would someone pay me $100 when they can earn an extra 1% a year for the same price?

Typically, the longer dated the bond the greater the price sensitivity of the bond.  This can be expressed in the bond portfolio’s duration.  A bond portfolio with a higher duration will have larger prices swings as interest rates move (in either direction) than a bond portfolio with a lower duration.

The nice thing about duration is that it gives you an easy way to calculate how your bond portfolio will change in value, given a change in interest rates. 

For example, if your bond portfolio’s duration is 5 then for every 1% RISE in interest rates, the value of your bond portfolio will DECREASE by 5%.  Similarly, in the case of a 1% FALL in interest rates,  the value of your bond portfolio will INCREASE 5%.  Note, this is just the value and does not include interest payments you receive throughout the year.

Given how low interest rates are now, in my next post I will detail what will happen if rates rise.

Treasury Yields are Low

The WSJ recently showed a Credit Suisse graph illustrating just how low interest rates are.  Instead of showing what the nominal yield is, the graph shows the real yield (yield less CPI).  The real long-term (note: it was not disclosed what long-term represented) yield appears to be right around 1% and near the all-time low. 

I did my own research (via FRED) and my data showed something similar.  What I did was take the 10 year Treasury yield and subtracted the YoY change in the CPI less food and energy.

• Average real 10 year yield since 1957 was about 3% with a standard deviation a little less than 2%.
• The all-time low was a little less than -3.50% in the 1970s.  The max was a little under 9% in the mid 1980s.
• Currently the real yield is essentially 0%; however, is still within 2 standard deviations of the average.  

Unfortunately from the link and my data there isn’t a lot I can conclude here other than that real interest rates are really low.  One would think real yields would have to rise at some point, but that still leaves a few problems.

1. When?
2. This says nothing about nominal yield and how to play the yield curve.

With regard to the first, I don’t think it will be soon.  Plus, you don’t want to “fight the Fed”.  With regard to the second, if we begin to have lower inflation or deflation and interest rates don’t move, real rates will rise, but if you bet on nominal yields moving up you would have lost.  Further, even though rates have crept up the move is still relatively small.

A Bit More on Home Prices

I have mentioned in the past housing prices might be near the bottom.  Unfortunately the recent data didn’t do much to prove me right.

First, the new Case-Shiller data shows the housing indices have once again hit new lows, although the year over year drop is decelerating or at the very least flattening.  We are in a similar place to where we were in 2003.  While the trend in prices is certainly downward, it isn’t nearly as steep as it was.

On a real basis, the graphs are worse.  We are at 2000 levels in prices, and further the graph shows a fairly steep decent in prices that appears further away from a bottoming. You can essentially pay the same amount for a house on an inflation adjusted basis as you did 12 years ago.

There is still positive news though:

• Price-to-rent ratio is way way down.  Meaning the substitute to owning is no longer a much cheaper alternative.  Still could fall some, especially if rents start to decline as homes become more affordable. 
• As I look at the trend lines, on a nominal and real basis prices are right at or slightly above the long-term trend line.

So while the latest news wasn’t so great, I am sticking with my previous statement – “the worst in housing appears to be over or close to being over.”

Corporate Cash on the Sidelines

It seems like one of the more common arguments for buying stocks, both now and in the past and presumably into the future, is the amount of cash on corporate balance sheets. 

The argument goes that such cash represents pent up demand that will eventually be deployed into the marketplace.  Once companies spend this cash, earnings and the market will propel higher.  But is this really the case?

Such talk sounds good, but appears not to be true.  There are a few reasons for this, many of which are outlined in this Big Picture article written by James Bianco.

First, cash on the sidelines is ALWAYS (almost) at record levels given that the number is nominal, meaning it is not adjusted for prices changes or output.  If you look at the first graph on the link, the line is linear.

Second, since the number is nominal, we need to compare it to something else.  The second graph on the link is liquid assets as a percentage of total nonfarm nonfinancial corporate business assets.  This amount has a long-term downward trend, meaning that cash as a % of total assets has been decline since the early 1950’s.

I should note if we look at the last 30 years we are at a high in this ratio.  However, given the high economic uncertainty and the fact the ratio isn’t astronomically high relative to historical standards, it is hard for me to compelled to believe this cash has to be put to work.

Lastly, I wonder how high corporate liabilities are.  There are two sides to the balance sheet, so for instance, if I have $100 in cash, but I borrowed $90 of it, I am less likely to go crazy spending the $100 given what I owe.

I believe markets can move higher, I just don’t believe cash rushing in from business investment is a compelling reason why this market will go up.