04-02-2002, 08:01 PM
As I posted below I said I liked High yield bonds for a few reasons - then it came up about bonds getting hammered in rising interest rate environments.
The part about rising rates and what is "priced in" is delicate but here goes.
Suppose the 1 yr rate is 3% and the 2 year rate is 5%. What is the market saying about the 1 year rate in the future? Well there are two strategies you can follow:
Buy the 2 yr and hold for 2 years - total return ((1.05)^2 - 1)*100 = componded twice at 5%
But the 1 year - then roll into another one year in one year. This roll rate is "traded" in the market. So by arbitrage this rate must be the x such that the above total return =
((1.03)*(1+x/100)-1)*100
This implies a value of x greater than 5% (someone can check the math)
Here is the thing. The market is "saying" that the future 1 year rate will be x. Which means if you buy a 2 yr at 5% today - in a year you can expect it to be priced with a yield of x!!!
Guess what your total return is if this actually happens...... 3%!!!!
So while a steep yield curve does say interest rates will be higher, if expectations are realized over a time period of y (one year in my example) you will earn the current y rate.
OK nuff about that,
High yield however is not strongly correlated with treasury interest rates. BB B have very low correlations with tsy's (both below .5)
So what would I expect from bonds - 3-5% for a year. High yield can easy do >10% (it did 2.3% in march so maybe we missed the boat )-:
The part about rising rates and what is "priced in" is delicate but here goes.
Suppose the 1 yr rate is 3% and the 2 year rate is 5%. What is the market saying about the 1 year rate in the future? Well there are two strategies you can follow:
Buy the 2 yr and hold for 2 years - total return ((1.05)^2 - 1)*100 = componded twice at 5%
But the 1 year - then roll into another one year in one year. This roll rate is "traded" in the market. So by arbitrage this rate must be the x such that the above total return =
((1.03)*(1+x/100)-1)*100
This implies a value of x greater than 5% (someone can check the math)
Here is the thing. The market is "saying" that the future 1 year rate will be x. Which means if you buy a 2 yr at 5% today - in a year you can expect it to be priced with a yield of x!!!
Guess what your total return is if this actually happens...... 3%!!!!
So while a steep yield curve does say interest rates will be higher, if expectations are realized over a time period of y (one year in my example) you will earn the current y rate.
OK nuff about that,
High yield however is not strongly correlated with treasury interest rates. BB B have very low correlations with tsy's (both below .5)
So what would I expect from bonds - 3-5% for a year. High yield can easy do >10% (it did 2.3% in march so maybe we missed the boat )-: