"The Point of No Return"

Now that we have had some stability in the global bond markets, it is right to ask if there is any value there for investors.

The answer to that question really depends upon your agenda. For most people, not losing any money is their default setting. Fortunately, there is a way of looking at this in the bond markets. Start with the equation:

Total Return = Income Accrued + Capital Change

Over any time period you can calculate the accrued income but, in the most pessimistic scenario, you have to budget for the capital (prices) change to be negative and to equal the income so that the total return becomes zero. In other words:

Capital Change = Income Accrued

Now,

Capital Change = Yield Change x Duration

Yield Change x Duration = Income Accrued

So...

Yield Change = Income Accrued

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Duration

This simple equation allows you to calculate the amount yields can rise over a specified time horizon before you start losing money. We'll call this the 'break-even yield change' or the 'point of zero return'.

Once you know the characteristics of a bond then you can compute the break-even yield for any maturity. This is particularly useful for performing calculations along the yield curve as you can get a sense of the kind of yield movements that can occur before you start losing money. It is also possible to make some judgements as to whether they are likely to occur over your specific time horizon.

We have built a system to do this for some 15 markets as part of our global bond process and the results following the recent yield rises are interesting. Using a target date of the end 2007, the result is, now that yields have risen there is quite a lot of protection built into the bond markets, though mainly in bonds with maturities between two and five years. For instance, in the US, yields would have to rise by an average of 1% in the short-end of the curve before you started to make an absolute loss by the end of the year. Given the state of the economics of the US (i.e. steady and unspectacular), there is a fairly low probability that yields will rise by that amount before year-end, and so short-dated bonds look pretty safe.

Do the same calculation in Europe and the UK and the yield protection in short-dated bonds is +0.9% and +1.2% respectively. Again, quite a lot of protection from making an absolute loss by year end.

Of course, this says nothing about what you could make by leaving your money in the bank, and with interest rates heading towards 5% throughout the west that isn't a trivial decision. You will also notice that as you step along the yield curve the protection becomes less and less. Because yield curves are so flat or inverted, slight twitches in yields over the next six months leads to an absolute loss very quickly. For instance the yield on a 30-year maturity bond in the US only has to move up by about +0.2% before you are in negative total return territory. This would put yields at around 5.5%, which isn't an unlikely scenario given the steady/robust state of economies in the west at this time. The same goes for Europe and UK and so, for the time being, these are areas best avoided by investors sensitive to absolute losses.

By adding on the 'break-even yield change' to current yields you can get a sense of what the yield curve would look like if yields rose to the point of zero (or no) return. This is a particularly interesting thing to do for the US (see first chart). As you can see the 'new yield curve' would be inverted. In other words, it is still priced for a recession and the yield curve is still not steep enough for economics. This is another reason to avoid the long-end of the US for the time being.