Bonds

I Savings Bonds are issued by the U.S. Treasury and pay an interest rate composed of a fixed rate that lasts for the duration of the bond plus a variable inflation rate that is determined twice a year. These two rates combined (fixed rate + inflation rate) are referred to as the composite rate. At the end of 2011, the fixed rate was 0% and the annual inflation rate was 3.06%.

In a September 30, 2011 piece on “60 Minutes,” Meredith Whitney, a well-respected banking analyst, forecasted “hundreds of billions of dollars’ worth of municipal bond defaults would occur within the next 12 months." In the months that followed, investors pulled out money from municipal bond funds for 29 consecutive weeks (note: municipal bonds returned > 10% for 2011). For 2012, the typical long-term municipal bond fund (with a 1.1% expense ratio) had a total net return of 8.9%. 

Resolution Trust securitization set the stage for modern-day CMBS. Roughly $30 billion of distressed commercial real estate debt was sold in 2011 and a similar amount for 2012. In 2007, the CMBS delinquency rate was less than 1%; during October 2011 it reached 9.8% (source: Trepp LLC).

As a group, emerging markets have debt equal to ~ 1/3 their GDP, half that of the U.S.  The average emerging market has a budget deficit of ~ 2% of GDP versus more than 11% for the U.S. The investment-grade portion of the J.P. Morgan Emerging Market Bond Index jumped from 2% in 1993 to 58% by November 2011; > 70% of the issuers in the J.P. Morgan Emerging Markets Bond Index are investment grade.

The returns on 20-year U.S. Treasurys have been amazing over the past decade (2002-2011) and over the past 30 years (11.03% vs. 0.05% for the S&P 500). This marks the first time that over any given 30-year period, Treasurys outperformed the S&P. For 2011, these long-term bonds had a total return of 28%; for 2008 the total return was 26%. These Treasurys have not seen a better year since 1995.

Duration, first developed in 1938 by Frederick Macaulay, measures bond price volatility. It is a weighted-average term-to-maturity of the bond’s cash flows; the “weights” being the present value (PV) of each cash flow as a percentage of the bond’s full price. The cash flows include the bond’s redemption value, typically $1,000 (discounted by the number used for PV—see below).