The Bond Volatility Haircut

The Federal Reserve's long experiment with its zero interest rate policy is looking like it is going to wind down over the coming months.  As the Fed withdraws its support from the bond markets, the price of Treasuries is likely to fall and, since interest rates move in the opposite direction to bond prices, the rates on government bonds will rise.  We're already seeing some evidence of that in the fixed income market as shown here:

One year ago, yields on a ten year Treasury note was 1.74 percent.  This has risen to just under 3.0 percent, a rise of 1.26 percentage points or 72.4 percent, a very significant increase on a year-over-year basis.  This is obviously a reflection of the market anticipation of the coming tapering.  On the price side of the equation, if we look back to December 27, 2012, the price for a ten year Treasury note closed at 132.74.  By December 26th, 2013, the price had dropped to 122.98, a decline of 9.76 or 7.4 percent.  That means that holders of ten year Treasuries saw the value of their holdings drop by $9.76 for every $100 worth of Treasuries that they held, a rather significant "haircut" also known as a capital loss.  This is where the problem will lie for those who have invested in market-traded fixed income products whether they hold them in kind or through a bond fund.  What is particularly concerning is the impact on the price of Treasuries down the road as tapering becomes more than just talk.

How bad could the fixed income haircut be?  Thanks to the American Association of Individual Investors, we can get a precise idea of how bond investments will be affected by changes in interest rates in both a rising and a falling interest rate environment.  Here is a chart showing what will generally happen to the price of both a 4 percent and 6 percent coupon bond for bonds with maturities of one, five, ten, twenty and thirty years when interest rates rise and fall by both one and two percentage points:

Here's a brief example showing how the table works.  Assume that you have a bond with a 30-year maturity and a 4 percent coupon.  If interest rates rise by a mere one percentage point, the value of the bond will drop by 15.5 percent, pushing the value of a $1000 bond down to $845.  If interest rates fall by one percentage point, the value of the 30 year bond rises by 19.7 percent to $1197.  If the interest rate rises by 2 percentage points, the value of a 30 year bond with a 4 percent coupon will drop by a very painful 27.7 percent, leaving the holder of a $1000 bond with only $723.  You can see that the longer the bond duration, the bigger the capital gain and capital loss experienced as interest rates fall and rise and the higher the coupon on the bond, the smaller the capital gain and loss since the change in interest rates makes up a smaller proportion of the coupon.  This means that the best way that bond holders can reduce the volatility of their bond holdings in a rising interest rate environment is to reduce the maturity length and increase the coupon interest rate.  You will also notice that the gains are always larger than the losses for the same interest rate change.  That's the mathematics of the relative change in interest rates.  It is this mechanism that has made investors that held bonds during the drop in interest rates since the Great Recession very happy.

The chart above gives us a rough idea of what will happen to the value of our bond holdings as interest rates change in the post-ultra-low interest rate environment.  While the trading price of low-rated (i.e. high yield or junk bonds) will likely be much more volatile (i.e they will fall far faster) than those bonds that are issued by more secure issuers, it is quite apparent that, in any case, there will be rather significant post-taper bond market "haircuts" for many investors, particularly since the impact of even a small interest rate increase on a the price of a low coupon bond is very significant.