Investors Record Exposure to Bond Duration Could Mean Trillions in Losses Should Interest Rates Rise Moderately

Inflation expectations around the globe continue to rise, hitting multi decade highs in some cases. With investors’ exposure to duration near record highs what may seem an unassuming rise in yields could inflicts trillions of dollars in losses.

Inflation expectations around the globe continue to rise, hitting multi decade highs in some cases. With investors’ exposure to duration near record highs what may seem an unassuming rise in yields could inflicts trillions of dollars in losses.

Duration move of 1 percent

Source: Blackrock

Inflation is not at the door step, it is knocking down the door.

  • The New York Fed’s one-year inflation expectations rose to 5.3%, the high for data going back eight years.
  • Excluding the summer of 2008, the University of Michigan one-year consumer inflation expectations at 4.8% were the highest since 1982.
  • The five-year Treasury “break even” inflation rate this week jumped 15 bps, that is up 23bps in just two weeks surpassing 2.9% for the first time in at least twenty years.

This Week’s Treasury Market

  • Three-month Treasury bill rates ended the week at 0.05%.
  • Two-year government yields jumped six bps to 0.455% (up 33bps y-t-d).
  • Five-year T-note yields gained seven bps to 1.20% (up 83bps).
  • Ten-year Treasury yields rose six bps to 1.63% (up 72bps).
  • Long bond yields added three bps to 2.07% (up 42bps).
  • Benchmark Fannie Mae MBS yields surged nine bps to 2.12% (up 77bps).

 

TNX W 10 22 2021

Central Bankers keep trying to reassure us that soaring inflation is transitory. September US CPI shows us it remains persistently high. Annual CPI was up 5.4% up from 5.3% in August with core CPI steady at a dizzy 4.0%.

United States Inflation Rate

Read More: Inflation Showing No Signs of Being Transitory Yet With US CPI Persistent Into September

What is Bond Duration?

Bond duration is a way of measuring how much bond prices are likely to change if and when interest rates move, it is measurement of interest rate risk. Understanding bond duration can help investors determine how bonds fit in to a broader investment portfolio. Duration is a key gauge of risk for bondholders that’s near record highs.

When interest rates rise, prices of traditional bonds fall, and vice versa. So if you own a bond that is paying a 1.05% interest rate (in other words, yielding .05%) and rates rise, that 1.05% yield doesn’t look as attractive. It’s lost some appeal (and value) in the marketplace.

Even a half-percentage point jump in yields from here, to roughly the pre-pandemic average in 2019, would be enough to reek havoc on funds. The knock on affect would be a threat with implications across asset classes, from emerging markets to high risk growth shares.

Duration is measured in years. Generally, the higher the duration of a bond or a bond fund (meaning the longer you need to wait for the payment of coupons and return of principal), the more its price will drop as interest rates rise. The point value on the thirty year bond is worth much than the 2 year for example. Meaning losses in longer duration paper are much larger. For example, if a bond has a duration of five years and interest rates increase by 1%, the bond’s price will decline by approximately 5%. Conversely, if a bond has a duration of five years and interest rates fall by 1%, the bond’s price will increase by approximately 5%. (image above)

If you expect rates to rise, it may make sense to focus on shorter-duration investments (in other words, those that have less interest-rate risk). With inflation soaring the pressure is on interest rates to rise, in this sort of environment, the focus on bonds that take on different types of risks becomes greater as investors seek bonds less affected by movements in interest rates.’

Treasury Yields Trending Higher

10-year U.S. Treasury yields bumped up against their peak levels of 2021 this week as bets were placed on the Federal Reserve  lifting borrowing costs next year. This came after Fed Chair Powell setting a defintive Taper schedule and the release of the Federal Reserve Beige Book

Beige Book Prices Summary

Most Districts reported significantly elevated prices, fueled by rising demand for goods and raw materials. Reports of input cost increases were widespread across industry sectors, driven by product scarcity resulting from supply chain bottlenecks. Price pressures also arose from increased transportation and labor constraints as well as commodity shortages. Prices of steel, electronic components, and freight costs rose markedly this period. Many firms raised selling prices indicating a greater ability to pass along cost increases to customers amid strong demand. Expectations for future price growth varied with some expecting price to remain high or increase further while others expected prices to moderate over the next 12 months. – Federal Reserve October 20, 2021

The potential for heavy losses comes as a legacy of longer-term borrowing during the era of historically low rates. Great for the borrower, not so much the lender is rising rates. Iutside the US we have seen inflation threats have induced many central banks to turn hawkish. The Brazil, Mexico, Poland and New Zealand Central Banks have all raised rates in the past few weeks.

“Higher rates is a systemic risk now,” said Barbara Ann Bernard, founder of hedge fund Wincrest Capital. “Higher rates are a headwind for everything, except banks. Also, the risk is that if inflation continues at these levels that growth will be very slow.”

The Wall Street consensus is for 10-year Treasury yields, which touched 1.7% this week, to reach 2% a year from now. That would put them in range of their 2.14% average for 2019. The rate has already surged about a half-point since early August.

The risk is global, this weeks 10 year bond price closes around the world illustrate this:

  • Greek 10-year yields jumped 12 bps to 1.03% (up 40bps y-t-d).
  • Portuguese 10-year Portuguese yields gained six bps to 0.41% (up 38bps)
  • Italian 10-year yields surged 13 bps to 1.00% (up 46bps).
  • Spain’s 10-year yields rose seven bps to 0.53% (up 48bps).
  • German bund (10-year) yields jumped six bps to negative 0.11% (up 46bps).
  • French Notionnel (10-year) yields gained six bps to 0.23% (up 57bps).
  • The French to German 10-year bond spread was unchanged at 34 bps.
  • U.K. 10-year gilt yields rose four bps to 1.15% (up 95bps).

Bloomberg estimated a half-point increase in yields, the Bloomberg U.S. Treasury index would incur over $350 billion in losses, given the roughly $10 trillion of debt it tracks and the surge in its duration in the past 18 months. The hit to the $68 trillion Bloomberg Global Aggregate Index — which includes corporate and securitized bonds of both developed and emerging markets — would be around $2.6 trillion.

Bloomberg Treasury Index

Bloomberg’s U.S. Treasury index has declined 3.3% this year through Oct. 21, on course for its biggest annual loss since 2009. This time the market at least isn’t underprepared should rates rise. The latest Bank of America Corp. monthly fund manager survey showed the most underweight in their bond allocation ever.

BAC Bond Market Survey Sept 21

For the time being every inflation measure, released from almost anywhere will be scrutinized. Coming up this week we get the monthy update on the Fed’s preferred inflation measure, the PCE Price Index, which rose at a 4.3% annual pace in August, the highest in more than a decade.

United States Core Personal Consumption Expenditure Price Index

The personal consumption expenditure price index in the United States rose 0.4 percent month-over-month in August of 2021, the same as in the previous month, driven by increases in cost for goods (0.6 percent vs 0.4 percent in July) and services (0.3 percent vs 0.4 percent). Within goods, prices were up for durable (0.9 percent vs 0.2 percent) and non-durable goods (0.4 percent vs 0.6 percent).

United States Personal Consumption Expenditure Price Index

Excluding food and energy, PCE prices edged up 0.3 percent, the same as in July and slightly above market expectations of 0.2 percent. Year-on-year, the PCE price index advanced 4.3 percent and the core index increased 3.6 percent.

keeping an eye on taper talk Hugh Gimber, a global strategist at J.P. Morgan Asset Management said “Core government bonds have historically been seen as a key source of diversification in a multi-asset portfolio. Today they are a key source of risk.”

Two big caveats will be growth, or lack there of from the supply constraints and low consumer sentiment seeing people simply ‘not paying up”, nevertheless keep an eye on bond duration and it’s influence across all assets.

Trade safe, trade smart

Source: Bloomberg Blackrock

From The Research Desk of TradersCommunity

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