Bond-fund charts of the day, rising-rates edition

By Felix Salmon
October 22, 2013
a bit obsessed with trying to get a feel for exactly how much money bond funds might go down if and when interest rates start to rise. And now, thanks to the wonderful Jake Levy at BuzzFeed, I can show you, in animated, rubbable-GIF form!

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I’ve been a bit obsessed with trying to get a feel for exactly how much money bond funds might go down if and when interest rates start to rise. And now, thanks to the wonderful Jake Levy at BuzzFeed, I can show you, in animated, rubbable-GIF form!

Jake put together two GIFs for me. Both show what happens to a $1,000 bond fund over time: the first one shows the value of the fund at various different durations, and assumes that rates are rising at a modest 0.5% per year; the second one shows the effect of the speed with which rates rise, assuming a constant duration equal to that of the Barclays US Aggregate. If you view these charts at BuzzFeed, on a touch device, then you can click the little hand in the top right corner, drag your finger across them, back and forth, and see how things change.

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These charts ultimately come out of a conversation I had with Emanuel Derman, and this clever tool from skewtosis. They’re also purely about interest-rate risk, rather than credit risk: the duration points and initial yields for the first chart correspond to the figures for the 1-year, 2-year, 3-year, 5-year, 7-year, and 10-year Treasury bonds.

As for the lesson to be drawn from the charts, one interpretation is that the big risk to bond funds isn’t rising rates so much as it’s rapidly rising rates. Sure, if rates rise slowly and your fund has substantial duration, then you could lose a bit of money. But if rates rise quickly, you could lose a lot of money. In the BuzzFeed version of these charts, which you can see here, I say that in a rising interest rate environment, it’s possible that bonds could actually be more risky than stocks. But I’m not sure what the implications are for asset allocation. Simon Lack, for one, would say that now’s the time to pretty much get out of bonds entirely, given their large downside and small upside. But I remember that Larry Summers managed to lose a billion dollars using the argument that “rates can’t fall any further”.

So maybe the real lesson here is simply that there just isn’t such a thing as a safe investment. Not even if it’s a Treasury bond.

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Comments
3 comments so far

Am I confused here or is the bottom chart not really showing “modest” increases? Even 1% per year is 10% over 10-years. That seems like a lot. 3% or 30% total sounds really high.

I guess I would be more interested in a rises for 2 years then stops view. I can imagine scenarios where yields “quickly” rise to 8-9%, but not cases where the rise continues. I think the chart would show a similar drop down in years 1-3, but then recover more quickly?

Posted by Dannupa | Report as abusive

According to this definition, a 30-day Treasury Bill is a very safe investment. Even if rates were to rise 3% overnight (implausible), the market value would fall just a fraction of a percent.

People spend too much time worrying about the dollar value of their portfolio, however, and too little worrying about the purchasing power of the income stream they hope to generate from that portfolio. Bonds can be a very safe way of assuring a certain income stream, if laddered so that the maturity matches the needs, however they offer no guarantee of purchasing power. TIPS attempt to promise both, but at such an abysmal rate of return that nobody would ever be able to retire.

It is a mistake to focus too heavily on a single risk and to ignore the rest. Market volatility is just one way that a retirement plan can go bad, and perhaps not the most dangerous.

Posted by TFF | Report as abusive

Hey Felix. You stumbled on something your friendly neighborhood quantitative analyst has known for some time. Often the best scenario for financial intermediaries is the slow rise. It allows the bank, insurer, or S&L to build income while not getting smacked with large unrealized capital losses.

Because so many intermediaries would benefit from it, is part of the reason why it almost never happens. Rates moving in anticipation of tightening Fed policy is almost never gradual.

Posted by DavidMerkel | Report as abusive
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