(Stock Index Performances as of 03/31/2010)

As we end the first quarter of 2010 sitting with one of the steepest yield curves in history, a recurring question is "What will happen to interest rates and what will that do to my bond portfolio?"

Steep Curve
Let's take a look at where we are now and make some estimates about where we might be in 3 years. Presently, this is what our interest rates look like:
2 yr Treasury: 1.02%
10 year Treasury: 3.83%
30 year Treasury (the "long bond"): 4.71%.

According to the Financial Times, until recently the steepest the 2 year to 10 year yield curve had ever been was 274 basis points (2.74%) and that was back in August of 2003. Currently, 2s to 10s is 281 basis points (2.81%). We are currently in the steepest yield curve environment in history.

History of Fed Tightening
The Fed has tightened money supply in 6 periods over the last 30 years. In 5 of the 6 periods, the yield curve was quite steep. In those 6 periods, the Fed Funds rate was increased by an average of 100% (doubled) and the yield increase on the 2 year Treasury averaged approximately 40%. For the 10 year and the 30 year Treasuries, the yield increased 8% and 5% respectively. For example, if the two year yield were 4%, a 40% increase represents a move to 5.60%.

History and the Possibility of a "New Norm"
Although historically a rate increase has resulted in a flattening of the yield curve, and although presently we are in the steepest yield curve environment we have ever been in, let's say for a moment that we are truly in a "new norm" and that we need to throw out all historic figures. Let's imagine that the Fed, over the next 3 years, raises rates 25 basis points a quarter, every quarter, for 12 consecutive quarters. Furthermore,  although this has never happened before, let's also imagine that the whole curve moves up the entire amount of the Fed tightening.

What 2013 Might Look Like
If we move forward to 2013 and we have experienced the tightening described above, here is what our interest rates look like:
2yr: 4.02%
10 yr: 6.83%
30 yr: 7.71%

The next question should be "what has my annualized return been in the bond market if I stayed with 2 year, 10 year, or 30 year bonds?"

Well, if you had held 2 year bonds, your annualized return would be approximately 1.10% over the three year period of increasing rates.

If you had held 10 year bonds, your annualized return would be approximately -1.05% over the three year period of increasing rates.

If you had held 30 year bonds, your annualized return would be approximately -4.10% over the three year period of increasing rates.

The above examples combine coupon income with the loss in value of the bonds held.

If however the bond yield curve flattened even 75 basis points (which is well within what Blue Haven Capital expects) all three annualized returns become positive.

Our Recommendation
We continue to advocate short, intermediate, and some long bonds in client bond portfolios. With current short rates at less than half of 10 year rates, it is too expensive to "hide" on the short end of the curve.

If history repeats itself and rates rise and the curve flattens, bond holders in all parts of the curve should come out just fine. The opportunity cost of staying short is over 2 1/2% per year...and 2 1/2% on a large portfolio starts adding up rather quickly over 2 or 3 years.

As always, we welcome your questions or comments.