Q. So “speed limit” is a new term bond traders are using to talk about the impact of rising rates…
A. Right. The “speed limit” of bonds is the amount of a rise in interest rates they can sustain before the value loss wipes out the coupon income. So if rates rise above the speed limit, the loss of value exceeds the coupon income. The term was inveneted by a couple of analysts at UBS, and is pretty handy was of thinking about duration and interest rate risk.
Q. Which we’ve talked a lot about over the last few months. So… what is the “speed limit” for bonds right now?
A. With rates as low as they are, it’s scary slow. For sovereign debt, just 2 or 3 one hundredths of a percent rise in interest rates per month wipes out the coupon interest for that month. For investment grade, its more like 5 or 6; and for high yield, maybe 13. We’ve had many single days lately where the moves have exceeded the speed limit.
Q. So what are the implications for all this out there in hedge fund land?
A. One thing is that its set off a big debate about the “risk parity” approaches at firms like Bridgewater and AQR. Those tend to make heavy use of leveraged fixed income positions, which could be extremely vulnerable to repeated violations of the speed limit… exactly what many folks expect if the Fed tapers.
Q. And Bloomberg is reporting today that Bridgewater has told its investors that it had underestimated the interest rate sensitivity of its All Weather Fund, and just recently sold off $40 billion or so of fixed income positions.
A. Right. So now the debate is whether their strategy is better protected against rising rates going forward. But it just shows you that “speed limits” don’t just apply to mom and pop investors… even the greatest hedge fund managers in the world have to obey the law of interest rates.