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Takeaway: If the SEC is tweeting this out now, we guess they are belting themselves in for higher rates.

By Moshe Silver

This just in: When interest rates go up, bond prices go down.

In case you didn’t know, now you know – courtesy of an SEC Investor Education tweet.

If the SEC is tweeting this out now, we guess they are belting themselves in for higher rates, and the near-certainty that retail investors are in for the shock of their life as they see the value of their bond funds erode. 

SEC: Worried About a Bond Bubble? - bub2

You Mean There’s Risk?

Media reports about “chasing yield” and the “bond bubble” warn about possible declines in bond prices if interest rates rise.  The Investor Bulletin says this interest rate risk is common to bonds, especially those with fixed payment rates (“coupons”) – including Treasury bonds.

After explaining the basic definition of “interest rate risk” – that bond prices rise as interest rates fall, and vice versa – the Bulletin explores the severity of a bond’s price movement associated with moves in interest rates (see Hedgeye’s Investing Ideas of last week, 2 August – Sector Spotlight: Financials – for a discussion of “duration”).  The lower the bond’s coupon rate, the greater the volatility in the price of the bond as interest rates change.

Using the Commission’s own example, if ten-year interest rates move from 4% to 5%, a Treasury bond with a 4% coupon rate will have to decline in price to adjust its current yield to the higher rate.  But a Treasury bond with a 2% coupon will have to decline much more in price to achieve that same 5% yield.

On the other side, the longer the maturity, the greater the price volatility in response to interest rate changes.  Conversely, shorter maturities are associated with lower volatility.  Thus, a 30-year bond will have much greater price volatility than a 2-year note. 

Finally, the Commission emphasizes that all bonds are subject to interest rate risk, even those guaranteed by the government.  The coupon payments are guaranteed, as is the final payment at maturity, but not to the price of the bond in the marketplace.

SEC: Worried About a Bond Bubble? - bub1

Your Tax Dollars Still At Work… Just Not As Many Of Them Any More

Fed Chairman Bernanke says he will continue buying tens of billions of dollars’ worth of mortgage securities every month to ease the burden on the nation’s banks by helping them offload debt.  But Bernanke’s jawboning has been increasingly ineffectual and the bond markets are moving on without him, counteracting the impact of the Fed’s ongoing QE efforts.

On July 31st the Chicago Tribune reported “bank portfolios have lost more than $36 billion of their value since the end of the first quarter, according to Fed data.”  Some banks have seen the paper profits on their mortgage-bond holdings drop by two-thirds in the second quarter alone, but “because of accounting rules, losses on mortgage bonds that banks hold in their securities portfolios do not affect their quarterly profits.”

Hedgeye pointed out in our Q3 Macro Themes that there is a massive supply / demand mismatch globally, with only about one-third of the world’s investment money in equities.  This is a historic low.  We think investors will continue to bid up equity prices while, in a mad dash for the exit, bond prices could be crushed beyond recognition. 

The lesson appears to be really simple: if you haven’t already sold your bonds, what are you waiting for?

What Are We Gonna Do With All Those Bonds? 

As bond prices decline, banks are not required to take a mark to market charge against earnings.  Still, the deterioration of their bond portfolios cuts into the banks’ net worth, which ends up affecting stock prices over the long term. 

Like other banks, the Fed carries its bonds at face value and doesn’t mark its portfolio to market.  But unlike other banks, the Fed doesn’t have to take a reserve against the billions of Treasurys and Fannie Maes – and other less savory securities – on its books.  The Fed doesn’t have a stock price to keep an eye on, or shareholders to worry about.  And the Fed itself, with its massive printing press, is the reserve.  (Well actually, the taxpayer is the reserve, as recent history continues to demonstrate.  If you want to see the Buyer of Last Resort, look in the mirror.)

The market value of the Fed’s massive holdings – currently over $3.3 trillion – could decline sharply in a rising rates environment.  This could turn into a boon for the incoming Fed chief.  (President Obama appears to have already “pre-fired” Bernanke, telling TV interviewer Charlie Rose in June that “he’s already stayed a lot longer than he wanted or he was supposed to.”)  Bernanke has said that, even after they stop the massive bond buying program, the Fed will continue to hold these bonds and not sell them back into the market.  Maybe the goal is for Bernanke’s replacement to coordinate with Treasury to retire billions of dollars’ worth of bonds at lower prices, covering them with newly-issued bonds at higher yields. 

Is this the Geithner-at-Treasury-Summers-at-Fed scenario?  Stranger things have happened in Washington, and will certainly continue to do so.  This would actually not be a great deal for Treasury, which would have to fund higher annual debt service.  And even though that bill would come due in some future, as-yet-undreamed-of Administration, we are already terrified at the thought that the new Masters of the Financial Universe will come up with a solution.  In the Orwellian world of Washington, this will be presented as “a win for the taxpayer.”  And no, you will not receive a check.

Fore-tweeted is fore-armed.

Moshe Silver is a Managing Director at Hedgeye Risk Management and author of Fixing a Broken Wall Street.