Understanding Bond Price Volatility

For our first e-Brief of the New Year, we would like to put a new twist on a familiar saying. It may be said that“In life, the only certain things are death and taxes”, but we would like to add a third certainty to the list – bond price volatility. From the European debt crisis to the Federal Reserve’s announcement of QE2, community bankers and portfolio managers alike had to react to a number of extremely significant events during 2010. On one hand, debt crises in the U.S. and abroad caused investors to bid up Treasury prices, while on the other, steadily improving economic data caused prices to fall. Despite the fact that the Federal Funds Rate remained unchanged from its range of 0.00-0.25%, bonds of all types showed, and continue to show, elevated levels of market price volatility.

Current Bond Market

After staying in a relatively stable range during the first quarter of 2010, yields on bonds exhibited increasingly larger swings for the remainder of the year. From their highs on April 5 through their lows on October 8, Treasury yields fell sharply, with yield on the 2 Year Treasury falling from 1.17% to 0.34%, and the yield on the 10 Year Treasury falling from 3.99% to 2.39%. Immediately after this rally in prices, bonds completely reversed their course and sold off for approximately two months. By December 15 the 2 Year Treasury yield was up to 0.67% and the 10 Year Treasury yield had risen to 3.53%.

Bond Prices and Income

During the 4th quarter of 2010, bond prices generally declined, as was noted earlier. Obviously, the first thing that usually comes to mind with declining bond prices is their impact on the market value of the investment portfolio. Bankers often have two common misconceptions when it comes to market values: if interest rates go up and the price of a bond goes down, the bank is losing; if interest rates go down and the price of a bond goes up, the bank is winning. However, bond price volatility is only part of the story. A bond’s current income also plays a major role in its performance. For example, suppose a fixed-income asset declined in price from $100 to $98. This decline equates to a $20,000 market value decline for every million dollars invested. A board member may question whether this was a good or bad investment, but market value gains and losses alone are just not enough information to make this determination. Why? If an investment lost 2 points, or 2%, in a year and the bond had a 5% coupon, the return on the investment over a one year would still be 3% (5% in income minus 2% market value loss). Investors should not forget to factor in current income and choose an appropriate time horizon when measuring a bond’s performance. Also, the bank’s asset/liability profile should be considered when evaluating bond price volatility. Generally, asset sensitive banks should be willing to take on some duration risk.

Tools and Techniques for Gauging Volatility

Expected and actual bond price volatility and the corresponding gains and loses have an effect on the investment decision process. Remaining focused and disciplined during these uncertain times is critical in forming a well thought out investment process. Below are several ideas to help investment strategy formation:

• Use Scenario Analysis: Model the existing investment portfolio and new security purchases using different interest rate, prepayment, and call assumptions. Applying various assumptions and interest rate scenarios can help identify which investments to avoid or purchase, and can also help uncover how cash flow and income can change under different scenarios.
• Perform Sector Analysis: Group individual securities with similar risk/return characteristics based on different criteria, such as their cash flow profile, starting yield or spread, and credit quality. Frequent portfolio re-sectoring is useful because securities change over time and over different interest rate scenarios. Also, one will be able to identify concentrations to see if the portfolio needs further diversification.
• Avoid Yield Chasing: In this low interest-rate environment many bankers have been guilty of trying to reach for yield by taking on excessive risks. Proper pre-purchase analysis typically would have uncovered these high-risk securities and would have prevented the initial purchase.

Conclusion: Bond price volatility will likely remain as we enter 2011. To deal with this type of environment effectively, it is important to remember that the market price of a bond is not “the be-all and the end-all”. Income, time horizon, and the A/L profile are important variables. Additionally, by performing pre-purchase analysis, including scenario and sector analysis, it may be possible to reduce some of the volatility risk associated with fixed-income investing.

Taylor Advisors, Inc. is a balance sheet consulting firm and a registered investment advisor based in Louisville, Kentucky. We are not a brokerage firm, but a team of asset liability analysts and balance sheet consultants to community-based financial institutions. Our service is quite simple. We help banks improve or maintain profitability while managing interest rate risk – what we call Balance Sheet Management (BSM). BSM consulting entails providing advice, strategies, monitoring, and most importantly, education in many areas: investments, asset/liability, liquidity/funding, and risk management.