portfolio managers debt, unrealized gains, interest rates and bond yields

Water Cooler Investing
#1

Something playing on my mind…

You have a portfolio with some bonds you account for them as held for trading so unrealized gains go to the I/S…

Now lets say interest rates go DOWN, so bond prices go up - this means you have unrealized gains in your portfolio which then flow to the I/S, which boost bottom line, correct?

Ok so interest rates go down, bond prices up and therefore yields go down…bad thing right, so this is reduced earnings as lower yield…?

I’m confused here if I’m a portfolio manager do I prefer higher yields or huge unrealized gains which i can then put on my books.

There are a lot of things at play here…type of debt its duration e.t.c bit confused.

#2

Interest rates going down is a bad thing for a bond portfolio if you haven’t bought your bonds yet, because now you can’t get as much return for your investment (a bit like the stock price going up is a bad thing if you haven’t bought your stocks yet).

So that means that bond yields going down is a good thing for your bond portfolio if you already have bonds in them, because the price goes up and your portfolio is worth more. It is a bad thing for any bonds you buy in the future.

At some level it may not matter. The bonds you have have gone up in value, but you can’t sell them and buy higher yielding stuff (unless you take on more risk). So if you think that rates have to go up soon, you might sell your bonds, hold cash until rates climb and then buy them again, but of course timing the bond market is unlikely to be any easier than timing the stock market, plus your investment mandate may not let you do something like that.

Let’s suppose your bond is worth 100 at a 5% yield and rates go down to 3%. Maybe your bond went up in value to 110 because of duration. You have more money today, but you’re effectively getting 3% on 110 rather than 5% at 100. So you get both a gain in present value but a reduction in future yield. Often it balances out, but if you are trying to time interest rates, or you have specific liabilities to neutralize and the durations don’t match, then you may want to trade them.

Ultimately, nothing has really changed, you’ll still get your payments as scheduled.

Stocks are not all that different, but stocks trade on price, whereas bonds tend to trade on yield. Plus the future cash flows from stocks are subject to much more uncertainty, which is why they have a required return. When a stock price goes up faster than its required return, if nothing has changed in the underlying business, it means that the future returns will now be lower, so if you have the stock in your portfolio, you have an unrealized gain, but a lower expected future return. With stocks, that’s often a sign to sell, because you figure that there might be some other stock that is undervalued and might do the same thing, and you can try to swich horses. It’s harder in the bond market because the differences tend to be on the order of basis points, but one of the advantages of the bond market is that it is substantially larger than the stock market (and can include non-public companies).

#3

Thanks for your reply, my takeaway from this is that the most important thing is your expectation of what interest rates will do.

Interest rates going up for alot of institutions with big bond portfolios is viewed as a positive, the benefits of higher yield outweigh any unrealised losses from bond prices…i guess…thinking looking at interest rates vs investment yields across time for insurance companies…anyway merry christmas!

#4

If you’re a bond person, your expectations about interest rates is probably one of the most important parts of your job, although one can just assume that the yeild curve contains the expected interest rates and take it from there if you want.

I think it’s a fair assessment to say that interest rates going up is probably good for fixed income as a whole, because it means that the PV of your portfolio can start to earn a higher rate of return.

The long end of the yeild curve is not likely to react too much to the changes in the Fed Funds rate because most people are assuming that if there’s an interest rate increase, it will happen sometime before the next 10 years is up. On the short end of the yield curve, the change in the Fed Funds rate will have a greater effect, but the duration of those instruments is also substantially smaller. So you are likely to take a small hit on bonds with short maturities, but then again, once they mature, you’ll be able to reinvest at the new higher rates, so on balance it’s likely to be good, even if a little bumpy.

#5

if you run a bond trading book, you don’t need to worry about the shape of the curve. another team will do that.

in fact if you try to claim profits from rolling down the curve or something you’ll simply get fired.

#6

It is an oversimplification to assume a bond person would follow these three steps…

  1. what is the speculated interest rate scenario in the relevant future?

  2. what sort of duration will benefit from that?

  3. seek bonds with the duration that fits… end of story (specifically looking at yield, price or maturity is not really individually important?)

…in other words, why look at anything other than duration?