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On Borrowed Dime Ather Bajwa, CFA

283 W Front St #302 Missoula, MT 59802

The US bond market is estimated to be worth about $39 trillion (world bond market is around $80 trillion) – twice the size of the US stock market. For many investors a bond is a plain vanilla instrument - a borrower “leases” cash from an investor and in return the investor is paid a rent (coupon) for the use of those funds with the promise that the borrower will Bond classification Estimated Value Municipal 3,729 pay all the money back at the end of a prearranged time (maturity). As a matter of fact, such Treasury 11,286 bonds are only a small portion of the overall bond market and a variety of other alternative Related 8,149 structures (think mortgage backed securities, floating rate securities and structured CDs) conDebt 9,236 stitute the bulk of the bond market. As with other investments, plain vanilla bonds, or one of Securities 2,071 its myriad variations, are not appropriate for all investors under all circumstances. Money Markets

2,492 1,691 38,654

While there are many types of bonds, two factors that influence their performance the most are Asset-Backed credit quality of the borrower and market interest rate. Greater the ability of a borrower to pay Total back the principal borrowed, lower the cost of borrowing. Germany can currently borrow for Source: SIFMA 10 years at 1.9 percent compared to France’s (a fellow AAA rated, Eurozone economy) cost of borrowing at 2.5 percent. Clearly investors consider Germany’s credit to be of higher quality than that of France.

Consider another example, let’s suppose I invest $1,000 in a US treasury bond with a 5 year maturity, paying 2 percent interest per year (basically I just lend the US government $1,000 for 5 years and in return it pays me $20 annual interest for 5 years). Suppose the next day the Federal Reserve raised interest rates (to control rising inflation) so that now new investors are receiving 3 percent interest on their investments as Credit 3-month 10 year inCountry compared to me. I am stuck with 2 percent for the next 5 years. If I wanted to Rating interest rate terest rate sell that bond to another investor they would balk at paying the original $1,000; United States AAA 0.26 2.8 Japan AA0.15 0.7 after all for $1,000 that investor can get essentially the same bond paying 3 China AA4.6 3.9 percent. Suddenly due to a change in market rate of interest my investment is Switzerland AAA 0.02 1.2 worth less than before (around $955 in this example - $915 if the bond was of Poland A2.5 4.5 10 year maturity instead of 5). Brazil

BBB

9

11.6

A similar abrupt increase in the market rate of interest is causing significant 8.3 South Africa BBB+ 5.1 grief to bond investors. For the first half of 2013, the Barclays US Aggregate Bond Index (a key measure of the bond market’s return) lost 2.5 percent – its worst performance in 20 years. Then, as now, the major culprit has been increasing interest rates – in May of this year the interest rate on the 10 year US treasury was 1.6 percent, it has since increased to 2.8 percent. To mitigate such increases in rates, there are a variety of instruments and strategies that can be employed. For one, shorter maturity (3 years as compared to 10 years) and higher credit quality bonds tend to perform well in a rising rate environment. Floating rate bonds offer variable rate coupons that adjusts as the reference rate changes – in other words a floating rate bond that is linked to the 10 year treasury would have adjusted its equivalent annual interest rate payment from 1.6 percent in May to 2.8 percent currently. In an increasing interest rate environment such bonds tend to perform well. Although the concerns of higher interest rates are real and current, investors should remember that all risk is relative. Over the past 50 years the absolute worst year to invest in bonds was 1994, when on average bonds lost 8.3 percent; on the other hand the worst year for the stock market was 2008, when stocks lost 39.5 percent. For investors, investment in bonds can provide a level of stability, a predictable income stream and protection of principal. As with other investments, bonds with their various connotations are a major diversification tool, and provide a variety of uses for investors of all stripes.

September 2013


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