My name is Bond: T-Bond

Bonds are considered to be safe but this will only be the case if positions are held until the redemption date in order to receive the interest payments, coupons, and the redemption is 100 per cent. However, if we take a look at the price development of US Treasury bonds, or T-bonds, the world's leading bond market, it shows clearly that another important risk has to be kept in mind: price risk.

At the end of 2006, the T-bonds were trading around 114, before falling to a current level of 109, after previously hitting a low of 104.5 (see chart). This means that, although an investor still collects the interest payments, the short term price loss on bonds would be approximately four per cent.

Duration

Large investors and financial institutions use duration to measure the volatility of the bond in order to monitor and modify their bond portfolios accordingly. Duration is stated in years. A five year duration means the price of a bond will decrease in value by five per cent if interest rates rise one per cent and will increase in value by five per cent if interest rates fall one per cent. Duration is a weighted measure of the length of time the bond will pay out. Generally, the higher the duration, the more its price will drop as interest rates go up.

If an investor expects interest rates to fall during the course of the time the bond is held, a bond with a long duration would be appealing because the bond's price would increase more than comparable less sensitive bonds with shorter durations.

In other words, the higher the duration is, the more sensitive is a portfolio to a change in interest rates. If an investor expects inflation pressure to diminish, which will push the price of long term bonds higher, the investor can buy longer dated bonds like T-bonds.

Inflation and sub-prime mortgages

One of the biggest factors driving bond prices is inflation, or rather, the expectation of inflation development. In May and June, the bond market was hammered because of inflation worries. This sell-off briefly pushed the yields of 10's and 30's to multi-year highs.

Also, troubles in the sub-prime mortgage market weighed on negative sentiment. Moody's and Standard and Poor's downgraded billions of dollars of bonds this month backed by sub-prime mortgages, citing higher than expected default rates. Sub-prime loans entering foreclosure rose to a five year high of 2.4 per cent in the first quarter. Two Bear Stearns hedge funds got into serious trouble and were faced with losses of billions of dollars.

Investors were afraid that this would have a spill-over effect on the economy. However, since mid-June, the bond market has shown signs of a recovery, also helped by positive comments by Fed President Ben Bernanke. He said that he did not anticipate a spill-over effect from the poor performing housing market on to the economy.

Federal Reserve

The Fed will meet again on August 7. Although the Fed will probably hold interest rates steady, the market is estimating a 12 per cent chance that the central bank will cut the Federal Fund Rate to five per cent by the year end. The current yield of the T-Bond is around 4.9 per cent.

This is interesting because the Federal Fund Rate has been held steady at 5.25 per cent for almost a year. This means that investors still expect lower rates in an inflation friendly environment. Also, the flight into safe havens like bonds has helped to drive current yields lower.

Profit

Neither me, nor my company Mercurious, has got a crystal ball with which we can look into the future, however, our strength is the knowledge of futures and options. With these products you can either profit from the next move, speculation, or you can use those instruments to hedge your portfolio against negative influences. Regardless of your area of interest: Good luck!