After
years
of
sleepwalking,
bond
yields
and
the
markets
that
trade
them
have
jolted
awake.
Central
banks
have
raised
rates
aggressively,
plunging
bond
markets
into
uncharted
waters.
There
are
a
few
rules
of
thumb
that
are
helpful
for
bond
investors
to
take
note
of
when
navigating
markets
like
this
one.
One
has
laid
dormant
in
the
fixed
income
markets
for
nearly
15
years:
a
concept
known
as
escape
velocity.
Let’s
dust
it
off.
Higher
bond
yields
realign
the
risks
investors
should
acknowledge
when
choosing
what
bonds
to
invest
in.
When
yields
are
low,
bond
prices
are
not
discounted
very
much
relative
to
the
face
value
of
the
bond
(effectively
the
amount
of
the
loan).
With
a
lower
price
cushion,
the
risk
of
capital
losses
–
that
is,
bond
prices
falling
owing
to
a
subsequent
rise
in
market
rates
–
is
high.
That
makes
a
bond
more
attuned
to
shifts
in
the
prevailing
interest
rate,
all
else
equal.
Duration
is
a
way
of
expressing
this
relationship
mathematically.
It
has
a
few
ingredients:
the
face
value
of
the
bond,
the
coupon
rate,
the
prevailing
market
interest
rate,
and
years
to
maturity.
By
discounting
the
cash
flows
back
to
today,
duration
gives
you
an
approximate
measure
of
a
bond’s
sensitivity
to
interest-rate
movements,
given
its
starting
yield.
A
good
rule
is
that
you
can
expect
a
bond
to
rise
or
fall
by
its
modified
duration,
which
is
denominated
in
years,
for
every
1
percentage
point
move
up
or
down
in
interest
rates.
We
can
illustrate
this
concept
with
a
hypothetical
$1,000
“plain
vanilla”
bond
that
matures
in
10
years
and
pays
out
an
annual
coupon
of
4%.
For
most
of
the
past
15
years,
bond
investors
operated
in
an
environment
where
yield
was
extremely
hard
to
find
–
not
too
dissimilar
from
the
first
two
rows
in
this
table.
As
evidenced
by
the
table,
lower
yields
modestly
extend
a
bond’s
duration,
creating
a
slightly
bumpier
ride
for
bond
investors.
In
those
types
of
situations,
it’s
almost
always
true
that
a
high-quality
government
bond’s
duration
is
greater
than
yield
to
maturity,
which
means
that
bond
investors
can
expect
a
negative
nominal
return
as
rates
rise.
Take
the
example
of
a
bond
priced
at
par,
found
in
Row
Two
in
the
table
above.
If
rates
rise
after
the
bond
is
bought,
the
fall
in
price
offsets
the
coupon
and
the
investor
loses
money.
Bummer,
right?
But
as
interest
rates
start
to
creep
up,
that
no
longer
has
to
be
the
case.
The
north
and
south
poles
of
bond
investing
invert:
yields
rise,
and
bond
prices
fall.
If
the
conditions
are
just
right,
yields
can
actually
overtake
duration.
That’s
where
escape
velocity
comes
in,
and
stuff
starts
to
get
really
weird.
How
Does
It
Work?
Let’s
take
the
example
of
the
bond
in
the
bottom
row
of
the
table
above.
If
rates
start
at
10%
instead
of
4%,
an
investor
would
pay
$631
upfront
instead
of
$1,000.
If
rates
rise
by
1
percentage
point,
the
bond’s
duration
of
7.2
means
it
will
lose
roughly
7.2%
of
its
value
–
not
fun.
However,
an
investor
still
has
a
margin
of
safety:
$632
is
a
lot
cheaper
than
$1,000, and they
still
have
the
same
amount
of
coupons
coming
in
the
door, and time
has
passed,
which
brings
the
investor
a
year
closer
to
their
bond
maturing.
Inclusive
of
all
of
those
levers,
one
can
expect
that
over
a
calendar
year
the
gears
of
bond
math
will
overturn
the
initial
price
decline
and
an
investor
will
end
up
with
a
positive
nominal
return
of
3.3%.
This
math
holds
over
the
entire
life
of
the
bond,
which
means
rates
can
rise
to
almost
19%
and
the
investor
will
still
end
up
with
a
positive
return.
In
the
current
interest-rate
environment,
escape
velocity
indicates
that
short-term
bonds
are
on
sale.
Investors
have
fled
the
asset
class
in
droves,
hollowing
out
that
bond
market
segment
in
favor
of
a
barbell
of
shorter-term
securities
like
money
market
funds,
which
have
even
higher
yields,
and
bonds
with
a
longer
time
horizon,
which
offer
more
certainty.
It’s
not
hard
to
figure
out
why.
Meanwhile,
cash-like
instruments
are
going
for
an
even
deeper
discount
than
short-term
bonds
are,
providing
all
the
income
that
some
investors
need
to
satisfy
near-term
goals.
This
article
was
adapted
from
our
US
website
but
the
illustrations
hold
true
for
bond
investors
wherever
they
are
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