A Tale of Magic

magician's hatAbracadabra! 2% is 3%

I was recently asked a question that I had not heard in over a decade or two.  The reason of course is because the risk associated with rising interest rates has not been the topic of news or discussion in quite some time.  The question was-why would I invest in short term bonds if short term interest rates are going up?  Assuming one must invest in something, the question really means, as always, is this a good investment for today?  Let’s learn some magic to see if this makes sense.  Let’s take a quick quiz because we are going to learn an important lesson in this tale and another lesson when we release A Tale of Duration at a later time.

First let’s learn the magic trick.  What would you rather purchase today, a 1-year bond that pays 1% or a 2-year bond that pays 2%.  I will give you a clue, I want you to imagine how much your 2-year bond will be worth a year from now when your 1-year bond matures and imagine how you will reinvest the money from the proceeds of the 1-year bond when it matures.

We know three things, a year from now, interest rates will have either gone down, stayed the same or gone up.  Depending on which scenario transpires will determine which was the better investment.

If rates went down, then clearly the 2-year bond investment was a better investment because at the end of the first year you have a piece of paper that pays 2% over the next year and the proceeds from the 1-year bond can’t be reinvested at a better rate.

Now the magic.  What if rates stay the same?  We know for certain that at the 1-year maturity you must reinvest the proceeds at 1% because rates stayed the same.  So, if you started out with $100,000 at time zero, you have $101,000 at the end of year 1 and $102,010 at the end of year 2.

But what about the 2-year bond?  If you started out at time zero with $100,000, you have $102,000 at the end of year 1.  But here’s the magic—you own a piece of paper that gives you choices.  The first choice is to hold it until maturity and the second is to sell it.  This is the magic.  How much is the 2-year piece of paper with 1 year left to maturity worth?  If you answered that it’s worth approximately $103,000 you would be correct.  This means that if you sold it at the end of the year you would have made 3% for the year instead of the stated 2%—-magic.  Abracadabra—2% is now 3%.  This magic trick has a term that seasoned bond investors call roll-down return but for our purposes it is simply a magic trick.

So, two questions remain unanswered.  Can I perpetually turn 2% into 3%?  In other words, can I do it again by selling my 2- year bond and buying another 2-year bond?  The answer is of course and what many professional bond managers actually do.  But at some point, interest rates will go up and there is a point where the 1-year bond would have been a better investment.  Is it a bet worth taking?  Since these tales are evergreen the answer is a resounding no.  It may be the smartest thing you can do today because nobody knows if this is the perfect time to initiate an inferior long-term strategy, but as an evergreen strategy the answer is no.

To be clear, if interest rates go down, the 2 year is better.   If rates stay the same the 2 year is better because of magic and lastly if rates go up, they would have to go up substantially for the 1 year to be better.  Can they go up substantially?  Of course, but it’s not something anyone can predict and it’s a bad bet to take.  Furthermore, when the inevitable does happen and rates have gone up substantially, you must still play the game and you are left with the choice of what do I do today.  At that point, you must once again decide to try to buck the odds or let magic be your friend.  I choose magic.

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