For someone who has now traded bonds professionally for over 30 years, the recent behavior of the bond market has been nothing short of incredible. For those who think of the bond market as a shelter from equity market storms, the results have been mixed, to be charitable. On the one hand short duration Treasurys have hung in quite well during the recent tumult. On the other hand, longer duration bonds have lost a lot of value. This dismal performance of longer duration bonds, both so far this year and in 2022 when the equity market fell almost 20%, has been incredibly disappointing.
To explore what is going on, let us take a fresh look at the fundamentals of the yield curve. The “atomic” risk-free asset is cash. Cash provides liquidity and store of nominal value. Just beyond cash is the Treasury bills complex, all the way from 4-week bills to 1-year bills. As we go from cash to T-bills we take a small amount of additional duration risk. Then of course is the world of Treasury notes and bonds. As we go from the shortest notes to bonds, the duration increases monotonically. The price volatility of a bond to leading order is simply its duration times yield volatility. Yes, there are other, higher order things such as convexity etc., but let’s keep it simple for this discussion and focus on duration. Duration is to the bond market that equity beta is to the equity market. Duration is the “risk-factor” that allows investors to quantify the risk-return tradeoff across the yield curve.
So here is what seems to be going on…
The full note on this important topic can be downloaded at this link:LTA Thinking -What’s Wrong With US Treasury’s Duration