Tag Archives: bond

Introduction of Treasury FRN

The Wall Street Journal reported that the U.S. treasury introduced new type of bonds into treasury bond markets. This new type of bond is a floating rate bond also known as FRN. This FRN provides different interest rates structures to investors. Its maturity is two years, and its interest rates payments depend on short term three-month treasury bill and the spread. The FRN pays out interest rates of three-month treasury bill plus the spread, which is the augmented interest rates on three-month treasury bill. For example, the spread of the FRN is 0.045%, and this week three-month treasury bill is 0.035%. Then, total interest rates of FRN is the sum of the spread and three month treasury bill interest rates, 0.08%.

This characteristic of FRN provides investors an opportunity to reduce potential capital loss, which can result from the increase of market interest rates. As the U.S. economy recovers from the Great Recession, there is a growing concern of the Fed increasing the federal funds rates. Early this year market experienced turbulence due to the Fed decision to taper its bond buying program. Once the Fed shows any signal to raise the federal funds rates in the future, market interest rates will increase rapidly. This increase of interest rates can be disastrous for the bond holders. As interest rates increases, the price of bond decreases.

In this situation, the FRN seems to be a reasonable investment tool for investors, especially for those who seek for short term safe investment opportunities. If the three-month interest rates increases to 0.050% from 0.045% in the coming weeks, then total interest rate of the FRN will increase to 0.085%. So, investors of the FRN will get capital loss from the increase of interest rates, but the interest rates of the FRN will increase too along with the increase of the three-month treasury bill, this increase of interest rates payment will compensate part of the capital loss of the bond.

This FRN also is good strategy for the U.S. treasury. As the economy recovers, the demand for long term bonds decreases. The U.S. treasury should pay more interest rates for issuing bonds to revolve maturing bonds. This worsens the burden of the revolving the current debt. But, with this FRN, whose interest rates are much lower than ordinary vanilla bond, the U.S. treasury can limit the increase of interest rates payments burden. In the meantime, for the long term investors, whose main strategy is to buy and hold, vanilla bond is much better investment option than FRN. Two-year treasury bill still pays $40 for $10,000 while two year FRN pays only $8 for $10,000.

Struggling PIMCO Takes Another Hit to Trailing Bond Fund

PIMCO (Pacific Investment Management Company, LLC), the global fixed income investment behemoth, has had a hard year. It’s flagship bond fund (and the world’s largest bond fund), the Pimco Total Return Fund, is currently on track this quarter to underperform 87% of its peers. As Min Zeng of the Wall Street Journal explains, the $236.5 billion fund had only a 1.28% year-on-year total return according to data from the fund tracker Morningstar. Pimco’s Total Return Fund falls well short of the standard bond benchmark, the Barclays U.S. Aggregate Bond Index, which reportedly returned 2.03% over the same period.

A number of factors have negatively impacted PIMCO’s success in the past year. In January, in a high-profile management struggle PIMCO’s chief executive Mohamed El-Erian stepped down after the firm’s bond funds stumbled and investors fled from the firm. In 2013 investors withdrew a net $41.1 billion from the Total Return fund, which was a mutual-fund industry record. The firm also appears to be riding the wrong wave, as the Fed has begun unwinding its Quantitative Easing policy, namely by decreasing U.S Treasury Bond purchases and signaling that interest rate increases are likely to arrive soon. As Jon Hilsenrath of the Wall Street Journal writes, many Fed officials believe that the central bank will increase rates soon, perhaps as soon as the end of the year. In addition, Janet Yellen, the Fed Chairwoman, has hinted that an increase in the Fed funds rate could come soon as well. Evidence of increases to interest rates has already begun to accumulate, as the U.S. Treasury yield curve, a plot of current interest rates of bonds at different maturities, has already shifted upwards in the past month. Screen Shot 2014-03-29 at 9.15.12 PMIn order to flatten out the yield curve, interest rates for 5 year and 10 year U.S. treasury bonds are increased. Since bond prices and interest rates move in opposite directions, this could be done by decreasing the price of bonds, which would occur if the Fed reduced the rate at which it purchased these bonds (demand for these bonds would go down, as would the price, and therefore the interest rate would increase). If we look at the Fed’s current holdings of U.S. Treasury bonds with yields around 10 years, we find that there is evidence that the Fed has reduced its purchases of bonds at this maturity. Here, we see the size of the Fed’s portfolio of 5-10 Year U.S Treasury bonds hasn’t changed much in the past year. Screen Shot 2014-03-29 at 9.31.29 PM


With interest rates set to rise, and bond prices therefore set to fall, PIMCO’s current investment manager Bill Gross is likely sweating bullets. However, Mr. Gross has weathered storms before at the helm of the Total Return fund, as he’s maintained a 5-year average annualize return of 6.9%, which is well above the benchmark’s 4.89% and above 55% of its peers. Only time will tell if Mr. Gross’s experience will be able to change the fortunes of his flagship fund in the face of turbulent bond markets ahead.

Fed Winds Down the Bond Purchases

The Federal Reserve announced that it would continue to slowly dismantle its stimulus campaign, citing “growing underlying strength in the broader economy”. As stated in Wall Street Journal, the Fed officials have become more optimistic about the U.S. economic outlook in the past few months. Though job gains slowed in December, the growth rate of gross domestic product appears to have accelerated to well over 3% in the second half of 2013.

As posted on The New York Times, stock indexes fell Wednesday as the Fed’s retreat rippled through global markets, making the money toward less risky investments like Treasury securities. Despite the positive effect on American economy, there would be some negative impacts on the global market. This action would have influence on global investment patterns as investors who look for higher returns in foreign markets are beginning to anticipate the return of higher interest rates in the United States. Countries like Turkey, depending heavily on foreign investment, would face a lot of problems. On the other side, investors seeking to control their risks are bidding up the price of Treasury bonds, which would offset the effect of the Fed’s gradual reduction in the volume of its own purchases. The problems in Turkey would somehow help to hold down interest rates in Omaha.

Dated back to September 2012, the third in a series of efforts also known as quantitative easing (QE). This program was to hold down long-term interest rates to spur borrowing, spending and investment. For now the Fed doesn’t see signs that it is spilling over into a larger problem that could damage the U.S. financial system or economy.

I agree that the clear Fed default position is to continue tapering. The Fed also keeps short-term interest rates near zero as it has been since late 2008. As we learnt in today’s lecture, the relationship between inflation rate and unemployment rate was negatively related that in order to keep the unemployment rate low, the inflation rate should be relatively high. Given that the current U.S. unemployment rate is quite high,  Fed officials repeated the message that they will likely keep rates at that low level “well past” the point at which the unemployment rate reaches 6.5%. The Fed had earlier set that as the threshold for starting to consider rate increases, as long as inflation remains in check.

Standing at the current point, I praised that Fed officials have made a great decision in dealing with the domestic economy. Let us keep following on the effects following by the Fed’s decisions.




Effects of signing Masahiro Tanaka matches the intentions of Fed’s QE?

Major League Baseball (MLB) is one of the most lucrative sports in the world. For example, New York Yankee paid $ 232,998,561 for their player’s salary in 2013. There were 33 players in this team so, NY Yankee have paid average salary of $7,060,562 to each of their players. Wow! Because of this fact, to some extent, I have a reason to believe that NY Yankees’ front office shares some similar concerns just like Federal Reserve and Ben Bernanke have. Like Fed worries about the U.S. economy and Yankees worries about winning at 2014 World Series. Today’s blog I would like to make a wild analogy by adding my personal opinions about Masahiro Tanaka’s signing seven year $155 million dollar contract to play for the Yankees. You can read a nice summary of Harvard Business School working paper inside SB Nation’s article, The Likely Financial Benefits of Signing Masahiro Tanaka, which will give you some insights about possible benefits of having Tanaka on Yankees other than him pitching the way people expect from him.

I may raise a lot of hit when I make a comparison that “singing Tanaka is like buying bonds” which Fed have interests tapering in buying recently. However; I still insist that I have found some value in my analogy. Here are my analogies:

  • Yankees Front Office = Federal Reserve
  • Masahiro Tanaka =  Bonds

Now I feel like I have to explain it more about this analogy. The simplest way I can explain is this: What Yankees expects from signing Masahiro Tanaka by paying him a lot of money, thus injecting money into the MLB market, is similar in a way that Fed’s expects from its QE to stimulate economy. Yankees wants more energy in their team, and Fed wants economy to circulate healthier. THEY BOTH PUT A LOT OF MONEY INTO THEIR OWN MARKET. Yankees has put their money in MLB market, Fed puts theirs in U.S Economy. In this respect, I have raised some philosophical questions about the economy in general.

Tanaka has a limit on his athletic ability. Yankees paid more than any other MLB team to see what Tanaka can do for them. Like Tanaka’s athletic ability, I believe that economy has some limit of boundary. Regardless of amount to being put into the market by Fed, it can only do for what it can do. Yankees paid $ 155 million dollar worth of “INSENTIVE” to Tanaka, yet paying him $ 300 million dollar worth of “INSENTIVE” to him will not make him to throw 150 mile/hour fastball in his every pitch.

Is it possible for Federal Reserve to have better and more precise analysis about the U.S. economy than the player’s, Tanaka, valuation and analysis completed by Yankees? In terms of the degree of completion, Fed can never have the complete analysis on economy. Because I believe that Fed has at least to consider hundreds of more variables than player’s valuation, more so each variable varies in time, which makes more difficult to predict than anticipating wining future baseball games. If we assume that the economy is a MLB baseball pitcher, do you think we have a pretty good idea whether the economy can throw 90mile/hour or 500mile/hour fastball today or tomorrow or ever? I am sure we know the lower bound of limit, but I am highly doubt anyone has clear idea about the upper bound of limit.

Of course, the economy is not like a person. However, it behaves like person. It grows.

My point is: Without having a clear idea about the upper and lower bound of the economy, having monetary policy can be like singing Tanaka for $10 billion dollars and asking him to throw 200 miles/hour fastball and expect him to win every game he pitches.

What if we are already asking too much out of economy? I cannot answer these questions, but it was fun pondering.

Increasing Bond Prices in the Wake of a Perceived Economic Recovery

With a burgeoning American stock market and the Fed’s announcement to start cutting back its bond-purchasing program, the field was set for bond prices to drop in the beginning of 2014. It seemed likely that investors, seeking higher returns, would shift their investments from bonds to equities. As a recent article in The Economist points out, however, this is not the case so far this year. Bond markets are actually doing surprisingly well.

Instead of rising since the end of 2013, yields on benchmark ten-year bonds, which are inversely related to prices, have fallen in America and Europe (see chart). Yields on US Treasuries have slipped from 3.01% to 2.88%; on British gilts from 3.03% to 2.86%; and on German bunds from 1.94% to 1.83%.

So far the story is pretty straightforward: yields on bonds are falling, causing bond prices to increase. Before we go any further I want to pause and ask a couple of questions in order to focus our analysis. (1) Why are bond prices and interest rates inversely related? (2) How are inflation, bond prices, and interest rates related? (3) Given we understand the answers to the previous two questions, why are bond prices rising in the wake of an apparent economic recovery? Shouldn’t demand for bonds fall as investors shift their money to the stock market?

(1) Why are bond prices and interest rates inversely related?

We answered this question in class today, but for the sake of clarity and my own learning I’ll summarize it again here. Purchasing a bond allows you to receive a stream of future cash payments from the borrower in the form interest payments (aka coupon payments) and the eventual repayment of the principal when the bond matures. Ignoring inflation expectations and credit risk, the bond price is calculated by summing the present value of each of these coupon payments plus the present value of the bond at maturity. To find the present value of each of these payments, their future value is discounted (aka divided) by the yield (aka the interest rate of the bond). Thus it is clear why a bond’s price and its corresponding interest rate are inversely related: as the interest rate rises, each coupon payment is discounted (aka divided) by a larger amount, causing the total bond price to decrease.

(2) How are inflation, interest rates, and bond prices related?

This is an important question that I don’t think we covered as much in class. I’m sure most people taking this class know the answer already, but it’s nice to get a quick refresher. Simply put, bonds hate inflation. High inflation and high-expected inflation cause future coupon payments to lose value. As a consequence, lenders demand higher yields (aka interest rates rise) and the price of the bond falls. This explanation, however, is a bit too simple. Inflation expectations affect short-term and long-term interest rates differently, so bonds with different terms to maturity will be affected differently. These effects are summarized quite nicely in a concept/graphic called the yield curve.

(3) Why are bond prices rising in the wake of an apparent economic recovery?

This question doesn’t have as much of a straightforward answer as the other two, but the main two reasons I’d like to discuss are low inflation expectations and poor job figures. As I’ve discussed in previous blog posts inflation rates across the developed economies have remained low and show no signs of rapid growth:

In America the price index targeted by the Fed (which aims at 2% inflation) has been rising by less than 1%. In Britain consumer-price figures published on January 14th showed inflation hitting the Bank of England’s 2% target, after four years above it. The fillip to bond markets from low inflation is stronger still in the euro zone, where consumer prices rose by just 0.8% in the year to December and core inflation (stripping out volatile items like energy and food) fell to a record low of 0.7%.

These low inflation figures cause long-term interest rates to fall, which, in turn, cause bond prices to rise.

Another reason is the underwhelming jobs figures that were released on January 10th:

Economists had expected employers to add around 200,000 jobs in December; the actual number was a lowly 74,000.

Poor jobs figures may be a sign that the economic recovery is not as strong as investors thought, causing some investors to hesitate in investing in the stock market and buy up bonds instead.