One month a trend not make, but in the relative scheme of things, May was a tough month for Treasuries. Yesterday in part due to a $35 billion two-year auction, 10-year note yields were pushed to the highest since April 2012. The two-year debt attracted the fewest bids for the securities since February 2011 with a bid-to-cover ratio of 3.04, compared with an average of 3.72 for the past 10 sales. Reaching 2.174% yesterday, the 10-year has breached the previous high of 2013. Although we have come off yesterday’s peak, rates on the 10-year continue to fluctuate between 2.14% and 2.15%.
Note the change in the yield curve since the beginning of the month:
The long term composite (aggregate of notes greater than 10 years) has increased 50 basis points since May 1. We have spent a great deal at the Bloodhound Exchange discussing bond yields including this post entitled the “Bond Conundrum.” 10-year Treasury rate is a mere 15 basis points higher than when we ran that post (as rates worked there way down), but the concepts remain solid:
On December 11th, with the 10-Year at 1.65%, we wrote the blog post, Are Bonds Riskier? We noted the risk that, “A slight move to a 2% yield would result in 3 1/2 points of lost value in that bond – approximately 2 whole years of interest. ” In the first month of 2013, that exact scenario has occurred. But the risk is hardly over.
An immediate move in rates to 4%, would see a corresponding drop in today’s on-the-run 10-year Treasury of 16 points. With the accommodative Federal Reserve, rates moving to 4% tomorrow is ridiculously unlikely – at that is what most bond investors are hanging their hat on. However, a 200 basis point move to 4% over two years is no less hard on investors. It’s still in excess of a 12.5 bond point move in the security, offset by only 3 points of cash flow from coupons.
It gets worse for individual investors. Investing straight up in Treasury bonds by individuals is not common. Retail investors tend to make their bond allocations through mutual funds and ETFs. The iShares 7-10 year Treasury Bond ETF (IEF) has a 12-month yield of 1.80%. Its expense ratio is low (0.15%), but is still 1/12th of the 12-month yield. The Fidelity Spartan® Intermediate Treasury Bond Index Fund, with a 0.2% expense ratio has a duration of 6.7 years, which suggests that 100 basis point move will result in a loss of approximately 6.7 points. Such a loss is twice that of its entire 2012 return.
With every Fed meeting and economic report, rates have bounced around. But the trend since last Summer is clearly upward.
In all it look like a fairly significant move … until you look at the 24 month chart.
and then the 30-year chart.
The Fed has spent close to five year manipulating rates. The process may not end tomorrow. It may not end in 2014. But it will eventually end.