Wednesday, 28 December 2011

Long and low and the outlook for bond price volatility

When thinking about bond price volatility it might be useful to have the image of a crocodile in mind. Modified duration (MD) - where the maths is not that challenging but need not detain us here - is a measure of the approximate sensitivity of the price of a bond to a given change in interest rates - say one percent.

The highest MD is to be found with low coupon bonds with a long time left to redemption, and a mnemonic for the notion of long and low that I have found useful is the image of the crocodile.

With the yield on 10 year UST's below 2% and 30 year UST's below 3% as we close out 2011 those portfolio managers that are stuffed to the gills with the aforementioned paper had better be hoping that interest rates continue to decline since they will be getting the best bang for their bucks if rates are going down. But then again one of the last places to be should interest rates begin to climb will be in high MD bonds.

Just to elucidate further, high duration and high beta are often considered together from the perspective of asset allocation. Just as high beta small cap equities are not a good place to be during a significant stock market correction, long and low UST's might just bite the hand that's feeding them when (eventually) rates start moving higher.

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