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Thursday, July 15, 2010

Stressed Out!!!!

I was getting so stressed out yesterday, reading about bond bubbles and the likelihood of an increase in interest rates and a consequent fall in bond prices, that I thought I should do my own stress test. My last stress test wasn't that easy. They put me on a tread mill, put it at a 46-degree angle and then turned up the speed. I had told them I was in pretty good shape and the stress test wouldn't be a problem. Little did I know. They pushed me to my limit, but that's the purpose of a stress test. Duh! When I got off the treadmill, I was sweating like a pig, my heart was pounding through my chest, and the dye was coursing through my body.

Fortunately, in the world of finance, stress tests aren't that traumatic - unless you happen to be math phobic. Take them a step further, and you can call them a "value-at-risk" (VAR) analysis and charge $1,000/hour as a hot-shot consultant (full disclosure: not what I do in my consulting work!). As a head's up, VAR is not foolproof ( as if anything is); just ask Long Term Capital Management. The largest hedge fund in the world went bust in 1998 when its VAR model broke down in the face of a "Black Swan" event.

Da' Stress Test
For my stress test, I wanted to get an idea of the impact of a rise in interest rates on bond exchange traded funds. To do this, I considered AGG--the iShares fund that tracks Barclays Aggregate Bond Index. For the uninitiated, this is the bond market's equivalent of the S&P 500. It is the index most professional bond managers go up against.

To do the test, you need duration and yield. Duration tells us approximately the percentage change in prices for bonds or for bond portfolios corresponding to a given change in interest rates. The change in yield plus the change in price then gives us the total return.

Let's do it for AGG. By going to Morningstar, we find the duration of AGG is 4.17 and the yield is 3.68. If interest rates rise 1% (100 basis points), then the average price of the bonds in the index will fall 4.17% ( this is what the duration measure tells us). But we will get 3.68% in yield over the course of the year. The total return then is -0.49%.

But what if yields rise by much more? What if the yield on the 10-year Treasury rises from 3.05% today to 5.05% next year this time? Then the approximate price change on AGG will be 2*4.17 or - 8.34 and the total return for the 12 months will be -8.34 + 3.68 = -4.66. Ouch!!!!

Quiz Problems
1. Find the 1-year total return for HYG if the 10-year Treasury yield increases from 3.05% to 4.55%.
2. Find the 1-year total return for TLT if the 10-year Treasury yield decreases from 3.05% to 2.05%.

What is the value at risk if we believe that the biggest change in rates is +2% and our portfolio is 50% invested in HYG and 50% invested in TLT?

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