This Depression-Era Math Is Working for Us Today
Editor's note: One discovery from more than 80 years ago revolutionized how economists look at risk. And as Joel Litman from our corporate affiliate Altimetry explains, it can also help bond investors navigate some turbulent times.
In today's Weekend Edition, we're taking a break from our usual fare with this piece, adapted from a recent edition of the free Altimetry Daily Authority e-letter. In it, Joel explains how this 80-year-old math discovery can help measure risk for bond traders – and what it's showing ahead for the credit market.
Frederick Macaulay spent nearly two decades fighting the next economic disaster...
It had been almost 10 years since the Great Depression kicked off. Macaulay was deep in his research on why events like this took place.
His findings couldn't have come at a better time. By 1938, folks were desperate for insights into how the economy worked. And Macaulay thought the answer could be found in railroads...
He was interested in how interest rates affected bond prices... and whether rates could be an indicator of future disasters.
Over the course of 17 years, Macaulay had gathered eight decades' worth of bond pricing data for long-dated railroad bonds. He pored over the data, making tens of thousands of calculations by hand.
And he realized that the market had it all wrong.
When determining how risky a bond was, credit investors were primarily looking at maturity...
The further out a bond came due, the less safe it seemed.
After all, there was no way to know what might happen in 10... 20... or even 50 years.
The logic seemed sound enough on the surface. But Macaulay discovered that relying on maturity alone could dramatically distort a bond's true value.
This was just the beginning of a discovery that can help you navigate a rocky credit market today...
To get a better idea of a bond's risk level, you needed to factor in basic data like price, maturity, and coupon.
Then, you needed to determine its duration.
Maturity is a date. It tells you when a bond contract ends – the day the company is legally obligated to pay you back.
Duration is a calculation. It takes into account how much cash you're earning while you hold the investment... and the impact of interest rates on that cash. Then, it tells you how long you'll have to wait (on average) to earn your money back.
Said another way, duration is the weighted average time it takes to receive all of a bond's cash flows.
Bonds with a high coupon rate have a shorter duration...
That's because investors get more money early on from interest payments.
Lower-coupon bonds have a long duration. Investors have to wait until maturity to get a big chunk of cash.
Let's say you have two bonds. Bond A has a coupon rate of 2%. It matures in 10 years, has a par value of $1,000, and trades for $800 today.
Bond B has a coupon rate of 10%. Like Bond A, it also matures in 10 years with a par of $1,000. And it also trades for $800 per bond today.
According to common logic in the 1930s, both bonds are equally risky... since they both mature in 10 years.
But Macaulay's duration theory shines a new light on these two bonds. Bond A's weighted average time to pay back investors is nine years. Because Bond B pays a higher coupon, it takes just over six years to pay investors back.
Said another way, Bond B is far less risky than Bond A.
Of course, the real calculation is a bit more complicated...
But this is the general idea behind Macaulay's research. His study revolutionized how economists judged risk.
How Macaulay's Discovery Works in the Credit Market
Before long, folks realized Macaulay's duration math had another important use...
It could measure the relationship between bond prices and interest rates.
When interest rates rose, bond prices fell. And when interest rates fell, bond prices rose. Creditors generally understood this concept a century ago. But with the power of duration, they could determine how much prices would change.
Investors discovered that bonds with higher durations saw much larger price swings when interest rates moved.
Despite these groundbreaking findings, Macaulay's research collected dust for decades...
Stable interest rates in the 1940s, '50s, and '60s meant bond prices behaved, too.
But as rates swung wildly in the 1970s, bonds once again followed suit. Creditors were desperate for a way to measure their risk.
That led them back to Macaulay.
As interest rates rose, bonds with longer durations saw the largest price collapses. As rates fell, those same bonds saw the biggest gains.
Macaulay's work was essential for navigating the turbulent credit market of the 1970s.
And it's just as important today.
The Federal Reserve has cut interest rates three times since September. And we expect plenty more when a new Fed chair steps up in May.
So-called "long dated" bonds have been dirt cheap for years... even those issued by the safest blue-chip businesses around.
But thanks to Macaulay's math, we know this won't be the case for much longer.
Long-dated bonds from household names like Microsoft, Disney, and Google parent Alphabet are about to soar. And my team and I have found eight "best of the best" picks trading at a steep discount right now.
For a short time only, we're offering access to this list (and more) for 50% off.
We have a short window of opportunity to buy in for a string of potential doubles, entirely outside of the stock market.
Regards,
Joel Litman
Editor's note: Near-zero interest rates are coming back fast. And thanks to a rare anomaly, one group of investments could double in the next year, with the risk profile of buying U.S. Treasurys. Two world-class analysts from our corporate affiliate Altimetry say it's the single best opportunity they've seen in decades – and today, they're breaking the story. But the window to act could close within weeks.