Bond Market Math (Part 1)

How can bond buyers make money?

Since 1981 bond investors have had the wind at their backs. Not only could they collect their periodic coupon payments, but as rates fell the market value of their bonds would rise. If investors wanted to, they could sell 10-year bonds 5 years after buying them and usually pocket a nice capital gain.

In spite of periodic sell-offs, outperforming an index was fairly simple: go long. Lower discount rates would cover a multitude of errors. The rising tide of lower rates would deliver market value gains that would outweigh any errant security selection.

But those days are over. Economic growth is rebounding around the world. Europe is emerging from recession; Japan is reflating; China is moving into the second year of its five-year-plan, and the US economy continues to grow in spite of Washington’s follies. Inflation expectations are muted for now, but with global central banks brimming with reserves, the risk is now be towards higher inflation. There is still much that we do not understand about the global economy.

So be ready, investors. The arc of the bond universe is long, but it now bends towards higher rates.

Douglas R. Tengdin, CFA

Chief Investment Officer

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