Want To Invest Like The Pros? Roll Your Bonds As The Yield Curve Flattens
In the beginning of time, BC (Before Children), I traded bonds at Prudential Securities. It wasn’t like the “Wolf of Wall Street” or even Bonfire of the Vanities, but it had its moments. We didn’t get a lot of training. As we came in the door we were expected to know things like convexity and duration. And to be able to parse out bond prices given interest rates, coupon payments, and maturities.
Two Important Lessons
We were told to stand up and stretch our arms out like airplanes, and then lean side to side. Then we were told to “hold” bond prices in one hand and interest rates in the other, and never forget that they moved inversely. It felt childish at the time, but it stuck.
We were also told, in no uncertain terms, to never fight the Fed.
But it only took a few days on the job to realize that instruction, both academic and practical, is different than reality.
Most investors, as well as professors, talk about bonds as staid, once-and-done purchases that sit on the shelf and gather dust.
But professional investors and institutions know better. Bond prices move, and over the last 15 years they have moved fast. When asset prices change, there’s an opportunity to make money – or at least improve your positioning. Pension funds, hedge funds, insurance companies, and other groups that hold large bond portfolios are constantly tweaking their holdings. Right now, with the yield curve almost flat, one of those opportunities is staring us in the face.
It’s Time to Roll
Rolling a bond portfolio, be it one bond or ten million, means to dramatically change the duration, or weighted maturity, of the holdings. The change in the interest rate environment dictates which direction to go. And right now the yield curve is telling us to come way in, exchanging long bonds for short bonds.
It’s all about risk.
The essential part of bond investing is trading time, or maturity, risk and credit risk for income. The longer until maturity, and lower the credit, the more investors should get paid for investing.
But sometimes these relationships get out of whack.
Today, the maturity risk to income relationship is skewed. Due to outside influences, the 30-year Treasury bond yields just 2.04%, while the six-month Treasury bond yields 1.90%, essentially the same, even though the difference in maturity risk is 29 and a half years!
If you’d purchased a 30-year Treasury bond a year ago at the prevailing rate of 3.04%, your bond would have increased in value by just over 20%.
This is where we “roll.”
Plot Your Move
The smart bond trade today is to sell long maturity bonds, capture the gains, and then reinvest in shorter maturity bonds that have close to the same interest rate. The reinvested capital gain will help make up for the lower coupon.
The risk in the trade is that interest rates might fall further, or the yield curve might steepen by short maturity bond yields sinking, which will cause reinvestment risk when the newly purchased bonds mature.
But the potential gain is that when long interest rates eventually move higher, investors will have captured and protected their capital gains and can use those proceeds to buy bonds with higher yield.
Unlike stocks, bond investments are made with an eye toward multi-year changes. To determine if you think this strategy makes sense, you have to ask how long will the 30-year Treasury remain at 2% or lower? One year? Two? Five?
It’s a game of probabilities.
Invest Like a Pro
Given what lies ahead with the U.S. elections, the lack of growth abroad, and central banks crushing rates to keep their economies upright, long interest rates in the U.S. could be low for a couple of years.
The flip side is that the long Treasury bond just touched the lowest price in history, so if we return to anything approaching normal, rates will move up by at least 200 or 300 basis points (2% to 3%), after this unusual period passes.
By rolling down bond maturities, investors give themselves incredible flexibility to make investment decisions in the future, and with the yield curve so flat, they don’t give up a lot of income to do it.
That’s a professional move that retail investors can consider at home.
Note: This article originally appeared at Economy & Markets. The author is Rodney Johnson.
Category: Bonds
