Last year, interest rates went up a lot. It was painful.
Somewhere in my writing—The 10th Man, The Daily Dirtnap… somewhere—I wrote about why a sustained bear market in bonds would be particularly agonizing, and it has to do with bond math.
With interest rates so low, many of the Treasury bonds issued had very low coupons—sometimes less than 1%. Debt with low coupons is very sensitive to changes in interest rates—in both directions. If rates go down, bond prices can go parabolic. If rates go up, they can crash. Interest rates have gone up in the past, but never from such a low level.
The reason is that low-coupon bonds have a very high duration (the weighted average time to maturity of all the coupon and principal payments). Most people know that zero-coupon bonds are the most sensitive to changes in interest rates, and that’s because the duration of a zero-coupon bond is equal to its maturity.
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Correspondingly, a low-coupon bond behaves similarly to a zero-coupon bond. At the lows in interest rates during the pandemic, the entire Treasury curve was basically zero-coupon bonds. To put this in perspective, at one point, the duration of a 30-year Treasury bond was about 23. That means that for every 1% change in interest rates, the price of the bond would change by approximately 23%.
Also, coupons on investment-grade and high-yield corporate bonds got pretty low, too, and people found that their safe, stable investment-grade bond mutual funds got taken out to the woodshed. It was all because of duration. High-yield bonds aren’t supposed to feel the effects of interest rates very much—their prices are mostly based on credit—but even high-yield bonds traded with duration last year. And let’s not forget the already-low coupon municipal bonds. And if you knew about the convexity effects of mortgage-backed securities, you would have been able to predict that mayhem, too.
When interest rates rose, many long-term Treasury bond prices dropped by 50%, making the bear market in bonds approximately equal to a generational bear market in stocks. If you’re watching from the sidelines, you might look at a chart of interest rates and say, “Well, rates went from 1% to 4%. What’s the big deal? Interest rates have been higher before.” This is why. It’s because low-coupon bonds have so much duration. Interest rates went up a lot in the late 70s and early 80s, but they did so from an already high plateau.
2022 was one of the worst years for bonds in history. Bet you didn’t know that, did you? It’s why 2022, from a financial standpoint, was one of the worst years for investors in the history of the capital markets. There was nowhere to hide.
What You Don’t Know About Finance
I tweeted once that if you only know about stocks, you know nothing about finance. If you know about bonds and options, you know everything about finance. If you’re punting around meme stocks and crap, you are basically a weathervane that is getting blown around by all the nonlinearity and convexity in the market. There have been some efforts made to educate people about options in recent years, but oddly, not about bonds. People have a basic understanding of what options did to GameStop and AMC, but people still have no idea what happened to the bond market in 2022.
A few years ago, I set out to change all that and came up with an investor education program known as the Bond Masterclass. Bonds are hard. It really helps if you’ve taken calculus. Options are even harder—you need high-level probability and statistics classes and differential equations as well.
But people like to learn about options because you can get rich with options, allegedly. Nobody learns about bonds because they are boring. But the slow, boring bond market has a lot more influence on your life than the stock market. When the stock market blew up from 2000–2002, we barely had a recession. When the bond market blew up in 2008, we almost had a depression. To err is equities; to really screw things up takes the bond market.
The Method
I strongly recommend that you invest in the Bond Masterclass and study its contents. You may never trade a bond in your life; that is not the point. The point is that you will become a more well-rounded financial citizen. And when you’re reading in The Wall Street Journal about a bond auction or the yield curve, it won’t go over your head.
In my experience, the vast majority of investors have no idea what the hell they’re doing when it comes to bonds. They invest in them without really knowing why. The Bond Masterclass gives you the way and the how.
If you understand bonds, you know how the world works. I hope you check it out.
Jared Dillian
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