tag:blogger.com,1999:blog-5908830827135060852.post1180246490549210438..comments2024-03-01T02:40:14.946-05:00Comments on Bond Economics: Primer: Low Yields and DurationBrian Romanchukhttp://www.blogger.com/profile/02699198289421951151noreply@blogger.comBlogger5125tag:blogger.com,1999:blog-5908830827135060852.post-28963212369922743482016-10-24T20:14:35.604-04:002016-10-24T20:14:35.604-04:00For the horizon idea, it works for small yield cha...For the horizon idea, it works for small yield changes. If you have a bond with a duration of 5, and the yield rises by 5 basis points, it would take 5 years for the extra carry of 1 basis point to cancel out the 5 basis point capital loss.<br /><br />For larger yield changes, the duration shifts as yields rise (admittedly not by a lot). Also, you would get extra interest on the extra interest for larger yield shifts. For example, if interest rates rise by 2%, you would get more than 10% more interest over 5 years.<br /><br />However, the level of rates is independent of that; that relationship is about the extra carry to match the capital loss. If the interest rate is 10%, the total interest income will cover a capital loss of 5 basis points in a few days.<br /><br />The short-term traders are always the loudest. But low yields are a disaster for institutions with high duration actuarial liabilities. You would be indifferent if you matched your asset duration to your liability duration, but very few North American pension funds did that. U.K. funds were pushed by regulation changes to match duration more, and they should be thankful.<br /><br />I had not responded to the Keynes sqare rule comment, but I wanted to point out that pretty well everyone in finance or people like bank regulators need to calculate bond portfolio durations to about four decimal places. I am not a fan of false precision, but I have been habituated to expect an interest rate risk measure that is unusually accurate. You want to have a good idea of your daily profit and loss, and yields only move five to ten basis points per day. So, I never spent much time worrying about rules of thumb. (When I was working on relative value trades, I probably had a good idea of the duration of all the benchmark instruments anyway, as I looked at them all day.)Brian Romanchukhttps://www.blogger.com/profile/02699198289421951151noreply@blogger.comtag:blogger.com,1999:blog-5908830827135060852.post-11233916579795132122016-10-24T17:22:38.579-04:002016-10-24T17:22:38.579-04:00The way I learned it is that the duration of a sec...The way I learned it is that the duration of a security is the horizon at which the capital loss from a rate increase just cancels out the value of the higher yields. If your horizon is higher than your portfolio's duration, you are happy when rates rise; if your horizon is shorter than the duration, you are sad. Is that right?<br /><br />It would follow that the people most likely to suffer from low rates are the longest-horizons investors, presumably institutions like insurance companies or pension funds. But instead, the loudest complaints seem to come from professional traders, who I would naively think would be shorter-horizon and therefore more sensitive to the capital gains low rates generate on their existing portfolios. But maybe they are speaking for their principals?<br /><br />Also, Keynes' square rule implicitly assumes that interest rates cannot be negative.<br /><br />JW Masonhttps://www.blogger.com/profile/14979669866721105903noreply@blogger.comtag:blogger.com,1999:blog-5908830827135060852.post-59908104372196038532016-10-19T06:47:01.252-04:002016-10-19T06:47:01.252-04:00(My earlier comments were in a primer about covere...(My earlier comments were in a primer about covered interest parity.)Brian Romanchukhttps://www.blogger.com/profile/02699198289421951151noreply@blogger.comtag:blogger.com,1999:blog-5908830827135060852.post-57486745967931055592016-10-19T06:37:56.551-04:002016-10-19T06:37:56.551-04:00Hello,
I will take a look at the article complexi...Hello,<br /><br />I will take a look at the article complexity; thanks for the feedback. Compared to what I am used to reading about bonds, that was simple... The digression on mortgage convexity hedging was something only specialists would follow, but it comes up a lot. I should relegate it to an appendix.<br /><br />I will append some charts for longer-dated bonds ("soon"). The reason I chose the 10-year as 30-year yields are further away from 0%, and it reflects bond index duration. Also, the only people who allocate money to 30-year bonds in any size need the duration.<br /><br />The issue with cross-currency swaps is more interbank credit risk. During the Financial Crisis, a lot of foreign banks were shut out of USD funding markets, and they used cross currency swaps ("basis swaps", although there are other types of basis swaps) as a USD funding vehicle. I wrote about that some time ago.<br /><br />Brian Romanchukhttps://www.blogger.com/profile/02699198289421951151noreply@blogger.comtag:blogger.com,1999:blog-5908830827135060852.post-68486455429452575162016-10-19T06:04:15.772-04:002016-10-19T06:04:15.772-04:00General comment: Brian, usually you do a good job ...General comment: Brian, usually you do a good job explaining things in terms understandable to lay people. But in this case I think that you will only get through to readers with a knowledge of bonds that is at least a grade above knowing that interest rates and price move in opposite directions. If you want to talk to economists/MMT types I would suggest assuming that all they know is that price and yield move in opposite directions. By that criteria, the above post was very hard to follow. The point you are making is an important one. It might be worth giving another shot. A reference to Keynes' squares rule would be nice for the more advanced monetary economists in the Post-Keynesian/MMT community (this paper is relevant to the above discussion and I think Kregel would appreciate the engagement: https://core.ac.uk/download/pdf/9314366.pdf).<br /><br />Particular comment: you say that most of the fear about the bond market at ZIRP is dependent on people holding a theoretical concept (consol pricing formula) in their heads that is largely inapplicable to the real world. Point well taken. But let's try to put some numbers on this. How far would you need to go out on the curve to get consol convexity effects? I mean, obviously none will be as dramatic as actual perpetuals, but surely there are some fairly deep markets that do have somewhat dramatic effects. After we've answered that step the next step is: how deep are those markets and how much damage could they do?<br /><br />It also strikes me that there are some pretty crazy derivative products kicking around today. Cross currency basis swaps stand out. These seem to definitely be sensitive enough to interest rate moves that they could potentially blow their lid at some point. I'm also not all that convinced that every bond manager knows what they are playing with when they play with these things.TheIllusionisthttps://www.blogger.com/profile/17642837989235595346noreply@blogger.com