Tags: Sloan | bond | Treasury | Fed

Fortune's Sloan: You Don't Understand the Bond Market

By Michael Kling   |   Thursday, 25 Jul 2013 12:00 PM

Did you notice a key segment of the bond market suffered a drop equivalent to a 600-point drop in the Dow Jones Industrial Average in a single day? Most people didn't.

The price of 30-year Treasury bonds plunged 4.1 percent on July 5, writes Allan Sloan, Fortune's senior editor at large. That would equal a 615-point drop for the Dow.

That goes to show that you don't know as much about bonds as you think you do. But most people don't either.

Editor's Note:
Tiny Loophole Found in 70,320 Page IRS Tax Code Could Pay $87,500

That's probably partly because stocks have the Dow and the Standard & Poor's 500, while bonds lack similar well-known tracking indexes. Sloan used a Bloomberg terminal to produce these figures.

Investors with $10,000 of the 30-year Treasurys due in November 2042 would have seen the value of their investment drop by $354. That's more than the $275 of annual interest the bonds pay.

This Treasury bond was recently selling for just under 84 percent of its face value. The loss in value since the bond was issued eight months ago equals almost six years' worth of interest. Investors holding the 30-year Treasury have lost a total of over $2.5 billion.

The 30-year Treasury bond price has been falling since July last year, Sloan notes. Meanwhile, the Dow is up 23 percent since last year, and the S&P 500 is up 26 percent.

"So we've had a big, endlessly discussed bull market in stocks at the same time we've had a far-less-noticed yearlong bear market in bonds, with the 30-year Treasury yield rising to about 3.65 percent from a low of 2.25 percent," Sloan states.

Values of long-term bonds fell even though the Federal Reserve bought about $1 trillion bonds over the past year. As their values fall, their yields rise. And values fell even though short-term bond rates, which the Fed directly controls, remain near zero.

Long-term yields jumped when Fed Chairman Ben Bernanke remarked that the Fed might start slowing its bond purchases later this year. But yields were already rising — and prices were falling — for 10 months, Sloan asserts.

Long-term rates are widely expected to rise significantly when the Fed stops buying bonds and eventually increases short-term rates.

But that conventional view is overly simplistic, Sloan insists. While rates will rise another percentage point or two, raising short-term rates could be lead to stabilization, or even eventually a drop, in long-term rates.

A similar phenomenon happened in 1995 and 2000, Sloan points out, perhaps because the Fed gave bond investors the impression that it was determined to control inflation, which erodes the value of long-term bonds.

In response to falling values, some investors turned to riskier junk bonds for higher yields. That strategy seems to have worked, at least for now, according to Forbes.

The SPDR Barclays High Yield Bond (JNK) exchange-traded fund yields over 6.6 percent and its values have been largely stable recently. However, that could change if the economy slows or rates increase quickly, Forbes warns.

Editor's Note: Tiny Loophole Found in 70,320 Page IRS Tax Code Could Pay $87,500

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