Why long-duration, low-coupon treasury bonds are about to return 25%

Sharing is Caring!

by Tendie_Tube

As we know, the prices of existing bonds go up as interest rates fall. Some of us even know that the sensitivity of a bond’s price to changes in interest rates is known as duration. Finally there is convexity – which is the curvature in the rate of change in a bond’s price as interest rates change.

Put all these factors together and you’ll understand why those 30 year treasuries issued in 2020 or 2021 at less than 2% coupon rates lost half their market value as rates rose. But what a lot of people don’t connect is how this escalator can go both ways. If rates fall, the same bonds that tanked a year or two earlier will deliver double-digit returns.

It seems highly probable for interest rates to fall from here, whether you believe in a soft landing narrative or if you believe there will be a recession. Real interest rates are at highs last seen before the GFC, we’ve just had 525bp in rate hikes occur in 18 months’ time, and CPI is falling fast. According to the CME FedWatch Tool, there is 100% certainty among market participants that rate hikes are done and rates will be lower this time next year. The shelter component is the only thing holding inflation above 2%. CPI minus the shelter component was +1.5% last month and falling. So it’s fair to say we don’t have an economy-wide inflation problem anymore, we have a housing (bubble?) problem the Fed is treating as if it is inflation.If rates are destined to fall soon, the bonds which will appreciate most are the ones with the majority of their cash flows far into the future. I.e. the ones with very low coupons, if any.

Here’s an example and an illustration of how the price will change:


Example bond: CUSIP: 912810SN9, a 1.25% 30-year treasury bond issued on 5/15/2020 which has lost 51% of its original market value, not counting interest.Let’s see what would happen to the value of this treasury bond if rates fell a mere 1%:

  1. Go to an online bond price calculator like dqydj.com/bond-pricing-calculator/.
  2. Plug in the following, to represent the treasury above:
    1. Face value: $1,000
    2. Coupon rate: 1.25%
    3. Today’smarket rate: 4.559% (using the 30y rates as a proxy for a 27.5 year bond)
    4. Years to maturity: 27.5 because the 30y bond was issued roughly 2.5y ago.
    5. Days since last payout: 7
    6. Coupon frequency: Twice a year
  3. Click “compute bond pricing”. I got $484.30 which is remarkably close to the $484.84 quoted by my brokerage, even though I approximated the YTM, market rate, and days since payout numbers.
  4. Now change the market rate to 1% lower (3.559%) and recompute. I got $597.13, a 23.3% increase in price.
  5. A 1% change in interest rates might occur over the span of a year or two, so we need to adjust down the “years to maturity” variable too. But this only helps the bond more, because the big $1,000 payout at the end gets closer. When I set years to maturity one year lower, to 26.5, I obtain $605.96, which is 25.12% higher than the current calculated price. Notice how I’m gaining almost 2% in value just from the passage of one year’s time.
  6. But what if I’m wrong and rates go up 1% instead of down 1% over the course of the next year? If I plug in 5.559% as the market rate, I obtain a price of $406.13, which would be a loss of -16.1%. This is the convexity factor! If rates go down 1% this bond will go up +25% but if rates go up 1% this bond will only go down -16%. The upside is literally and mathematically 9% higher than the downside! The odds are definitely in your favor here. Even if you think the future direction of rates is a coin toss, the market is offering you a big fat advantage and you should always take a coin toss bet when offered odds in your favor.
See also  Unstable U.S. Treasury Market Experiences Its Worst Day in the Last Six Months


Zeros If You Want To Swing For The Fences

The crazy thing is there are bonds with even higher convexity than this one, such as CUSIPs 912803GS6 or 912803GU1. These are “strips” or zero coupon bonds with a lot of years to maturity. They are hyper sensitive to changing rates, and only sell for about $275 for a $1k face value.

Why Not Just TLT or ZROZ?

A lot of investors are shy about buying individual bonds because the process is slightly more complex. I suggest getting over one’s fears and learning the process.You could just invest in TLT or ZROZ, but the disadvantage here is that you cannot specifically target the longest-duration, lowest-yielding, highest-convexity bonds. You simply get their whole portfolio. Plus, they are constantly turning over their assets so as the change you forecast occurs, your funds are getting out of exactly the assets you’d want to be in to realize gains in that scenario! I think these will do well, but not as well as the specific examples listed here.Nonetheless, I use TLT and ZROZ to invest leftover cash in my account and interest payments, as these amounts are too small to buy individual bonds with minimum lot sizes of 5 or 10.

See also  Alarming economic indicators from Germany: Construction PMI hits a new low, factory orders decline, raising concerns about deflationary pressures ahead.

Why Not Corporate Bonds?

For one, most of these are callable which means the issuers can just pay off your bond and take out new loans at lower rates. This callable feature will reduce the gains for these bonds. Secondly, with corporate bonds you are taking on credit risk. In a severe recession these bonds might lose some of the value they’d otherwise have due to downgrades or investor risk aversion. Third, bonds with higher coupons sell for less of a discount and are less sensitive to rate changes.

Strategic Plan

If stocks fall 20% from ATH’s or if a recession occurs I plan to sell these bonds for fat profits and redeploy my little green soldiers into a newly-cheap QQQ while everyone else panics. I have no time limit like I would with options. Instead, I make gains from the passage of time. My thesis could pan out next year, in 2 years, maybe even in 3 years and I’ll still make decent returns. Basically, I’m loaded for the ideal strategy a person could have been following prior to a 2007/2008 scenario, but will make acceptable returns even in a soft landing. I don’t think now is a good time to be exposed to credit or market risk, but I think it’s a great time to be exposed to falling interest rates.I personally suspect we are in a housing bubble like in 2007 due to extreme low affordability, a culture of FOMO, scammy investment fads, and rising mortgage rates. Either rates fall or prices will have to fall. Either way I’m well positioned.

Disclosure: I own the bond used as examples here, some zero coupon bonds, TLT, and ZROZ. I entered my positions in late October / early November and I’m sitting on gains so far.


Disclaimer: This information is only for educational purposes. Do not make any investment decisions based on the information in this article. Do you own due diligence or consult your financial professional before making any investment decision.

Views: 120

Leave a Comment

This site uses Akismet to reduce spam. Learn how your comment data is processed.