Bond Prices: What Has Gone Up Must Come Down

Yesterday, the Congressional Budget Office came out with its budget and economic forecast through 2023.  In it, they project that the ten year US Treasury Bond will average a 5% yield in 2017, compared to 2% today.  This is only four years away.  With many investors holding bonds for their safety, I wanted to illustrate what would happen to bonds if that projection was accurate.  I looked at both a current ten year Treasury bond and a fourteen year bond that would be a ten year bond in 2017.  According to the Wall Street Journal, as of the close of business on 2/15/13, these were priced as follows:

Maturity	Price	Coupon	YTM
8/15/2023	140.08459	6.250%	2.007%
2/15/2027	149.14204	6.625%	2.461%

In early 2017, the 6.625% bond maturing on 2/15/2027 will be a ten year bond.  If it were to yield 5% at that point, it would be worth 112 for over a 24% drop in principal value.  Fortunately, some of that loss would be offset by interest income, so the total return would be roughly -6.7% over the next four years, or -1.7% a year.   In four years, the 2023 bond will be roughly a six year bond. If the yield curve stays approximately the same shape, we could assume it would yield around 4.12% and trade at 112. This would be a 20% drop in value in the principal. 

 

 

The other thing to keep in mind, is that the premium price on these bonds will naturally diminish (or amortize) as it approaches maturity, when it will be redeemed at par (100). If the ten year rate were to stay at 2%, the value of the 2027 bond would still decrease, but to only 141, or a 5% loss.  Similarly if yields on a six year bond were to stay at 1.12%, the 2023 bond would still drop around 6% in value as the premium amortizes. 

Investment grade corporate bonds with their higher yields offer a bit more protection in this regard.  However, the spreads over US Treasuries are between one and two percent depending upon maturity.  The cushion is not that large, given the current low rate environment.    If spreads stay stable, they will suffer losses as well. 

 

Alot of money has flowed into bond funds over the last few years. It will be interesting to see how those investors react if under either scenario.   




Note: This post was updated 2/13/13 with revised data.  The original prices under both scenarios were incorrect due to a data entry error.  The revised data shows a slightly smaller principal loss (24% vs 27% and >20% vs 20%) under the baseline scenario and a small principal loss under the unchanged rate scenario (5% vs 16% and 6% vs 8%).  The main implications are unchanged.