Understanding Bond Duration
I've been investing for over 35 years and over that time, I've made many mistakes. I define a mistake as a decision I would have made differently if I had thoroughly reviewed the information that was readily available to me at the time of the decision.
A decision I made based on my ignorance of Zero Coupon bonds cost our family office many hundreds of thousands of dollars. Here's what happened. In December of 2010, the yield on the 30 year Treasury had moved up to the 4.5% range. Compared to the equity market, we thought that yield was attractive. Our thesis was, if, at some point, there was another crisis or slowdown in the economy, yields would drop; we'd sell the bonds, make some money, and redeploy the funds into the equity market when it was at a more attractive valuation. At a 4.5% yield, we were content collecting interest and waiting for a better entry point for equities.
We had no timetable for the trade. It might take 3, 5, or 7 years for there to be an opportunity. We put on a very large position in 30 year treasuries and while we waited, we collected 4.5% interest. Getting paid to wait is a general theme of our investing. We didn't have to wait long for the next crisis. Over the following summer, Congress threatened to not raise the debt ceiling; consequently, yields on Treasuries plummeted. By October, the yield on the 30-year was well below 3%. We sold our Treasuries and redeployed the funds in equities. Our timing wasn't perfect, we sold when the yield was around 3.5% but that wasn't the mistake. We had no information at the time that the yield would continue to drop.
We made a little over 15% on the trade and felt like we implemented our thesis in the best way possible. A few months later I was discussing the trade with a friend and he detailed how my ignorance of implementing our strategy reduced our gain on the bonds from 30% to 15%. He wanted to confirm that the strategy behind choosing the 30 year was to maximize the gain if yields dropped. I told him it was, and that also the 30 year had over a 100 basis point yield premium over the 10 year.
He told me the duration of a 30 year Treasury that had a 4.5% yield was a little over 16.5. That means that for every 1% change in the yield, the value of the bond should change by 16-1/2%. He said a better implementation of our thesis would have been to buy 30 year Treasury Zero Coupon bonds. They have a duration of 30, which means that instead of making 16.5% on the 1% drop in yield on our bonds we would have made 30%.
This was clearly a case of not researching the best implementation of the thesis. I was familiar with the duration of the 10 year Treasury. At a 4.5% yield, the duration is 8.2 years, which is not that much different than that of the 10 year Zero Coupon. I didn't realize that when you stepped up to a 30 year bond, the difference between the Zero and the conventional was so large.
A few phone calls to friends in the investment industry would have significantly increased our profits. One of the lessons I learned from that is the importance of sharing ideas with colleagues and paying close attention to their suggestions/critiques before making trades.
