Monday, August 22, 2016

You want to own the longest maturity bond if you believe Interest Rates will go down

We’ve been pretty lonely as Treasury bond bulls for 35 years, but we’re comfortable being in the minority and tend to make more money in that position than by running with the herd. Incidentally, we continue to favor the 30-year bond over the 10-year note, which became the benchmark after the Treasury in 2001 stopped issuing the “long bond.” At that time, the Treasury was retiring debt because of the short-lived federal government surpluses caused by the post–Cold War decline in defense spending and big capital gains and other tax collections associated with the Internet stock bubble.

But after the federal budget returned to deficits as usual, the Treasury resumed long bond issues in 2006. In addition, after stock losses in the 2000–2002 bear market, many pension funds wanted longer-maturity Treasurys to match against the pension benefit liability that stretched further into the future as people live longer, and they still do.

Maturity Matters

We also prefer the long bond because maturity matters to appreciation when rates decline. Because of compound interest, a 30-year bond increases in value much more for each percentage point decline in interest rates than does a shorter maturity bond.

Note that at recent interest rates, a one percentage point fall in rates increases the price of a 5-year Treasury note by about 4.8%, a 10-year note by around 9.5%, but a 30-year bond by around 24.2%. Unfortunately, this works both ways, so if interest rates go up, you’ll lose much more on the bond than the notes if rates rise the same for both.

If you really believe, as we have for 35 years, that interest rates are going down, you want to own the longest-maturity bond possible. This is true even if short-term rates were to fall twice as much as 30-year bond yields. Many investors don’t understand this and want only to buy a longer-maturity bond if its yield is higher.

Others only buy fixed-income securities that mature when they need the money back. Or they’ll buy a ladder of bonds that mature in a series of future dates. This strikes us as odd, especially for Treasury's that trade hundreds of billions of dollars’ worth each day and can be easily bought and sold without disturbing the market price. Of course, when you need the cash, interest rates may have risen and you’ll sell at a loss, whereas if you hold a bond until it matures, you’ll get the full par value unless it defaults in the meanwhile. 

But what about stocks? They have no maturity, so you’re never sure you’ll get back what you pay for them.

via forbes