Bonds TL;DR

Too Long; Didn't Read. Imagined history of how bonds became complex things.

Holiday Divergence Alert!

Dear Readers,

In the spirit of the holiday season, I'm taking a whimsical detour from our usual discourse.

While it may not directly address the immediate concerns of retirement planning or the campaign for Modern Tontines, it's a nod to the broader narrative of finance and how understanding its roots can give us perspective on its present and future.

So, grab a cup of your favourite seasonal beverage, settle in, and enjoy this light-hearted journey through an imaginary financial history. We'll return to our regular programming soon.

Wishing you a joyous holiday!

Picture it: some time ago, in an era draped in the mists of history, a person needed money and thus approached another for a loan. They struck a deal, simple on its face: borrow a sum now, repay 100 ducats later, and to sweeten the pot and signal trustworthiness, they'd toss in a little extra—a "coupon"—periodically. Thus, the bond waltzed into existence.

They calculated the cost of this arrangement with a discount for the risk of default and compound interest, a concept older than the abacus—maybe not that old, but you get the idea. Easy peasy.

This borrowing-lending tango caught on like wildfire. Before you knew it, bonds proliferated, breeding an entire ecosystem of debt. People began trading them, passing the promise of repayment around like a hot potato. Then, in a stroke of genius or greed—perhaps both—a canny individual or a cabal thereof gathered funds from various folks to acquire a bouquet of bonds, thus birthing the first bond portfolio.

Now imagine our pioneering portfolio manager, basking in the glory of his aggregation, suddenly tasked by his superior to summarise this diverse collection. Each bond, after all, was a unique snowflake: varying maturities, differing coupons, and distinct default compensations. The numbers didn't line up neatly. Panic likely set in. What was one to do with such a motley crew of financial instruments?

Then, a spark of genius: What if he presented the various bonds not as prices but as internal rates of return? Uniformity out of chaos, a mirage of understanding amidst the financial fog. He embarked on a calculating odyssey, iterating guesses and refining rates. When the dust settled, he beheld his masterpiece: a list where the riskiest bonds boasted the loftiest IRRs and government bonds humbly anchored the bottom. A presentation sure to dazzle his boss.

And he was right; his boss loved it. He started talking to clients and potential clients about the yield on the portfolio and the "spread" over government bonds you could get by buying the risky ones. As money flowed in, our portfolio manager became a veritable financial maestro, toasted in every dimly lit banker's haunt. If this were the end, what a charming tale it would be! But alas, beneath the veneer of success, the seeds of complexity were germinating, poised to sprout thorns.

Eventually, as interest rates climbed and defaults rippled, our once-prized portfolio diminished in value. Investors, those knights of the high yield, clamoured for explanations. The price dipped, and discontent simmered. "Why?" they demanded, unsatisfied with tales of inverse relationships. It might have been our beleaguered manager or perhaps a wunderkind from the quant corner who ushered in the era of 'Duration'—a concept as misleading as it was essential, veiling bonds in a shroud of complexity.

Duration, the financial world's newfound oracle, answered how much prices pirouette with yield shifts. Yet, this was the wrong riddle being solved. The real enigma lay in how prices swayed to the tune of shifting interest rates, default risks, and the capricious winds of future forecasts.

But the plot thickened as whispers grew that price and yield didn't dance a straightforward tango but rather a more complex, curvilinear waltz known as Convexity. This arcane term became the secret handshake of financial savants, signifying the intricate ballet of market movements. The genie was out of the bottle, destined to perplex legions with talk of Duration and Convexity, often earning a glazed-eyed TL;DR 'Too Long; Didn't Read.'

One might wish for universal apathy as a mercy. Yet, a new doctrine emerged for the devoted disciples who delved into these depths. They'd chant about widening spreads like doomsday prophets, revelling in the esoteric nuances of their portfolios. They found delight in the oddity that their assets wouldn't flinch quite as much as Duration's dreary predictions, a testament to the seductive allure of Convexity's charms.

In my mind's eye, I envision our original portfolio manager, now a spectre in the financial ether, frantically gesticulating and lamenting the confusion he unwittingly sowed. 'You've got it all wrong!' he cries as the market attributes bond price gymnastics to the waltz of yields and spreads, mistaking descriptive markers for driving forces. Yet, his cries fall on deaf ears, lost amidst the din of trading floors, as investors and analysts continue to chase these shadows, believing them to be the puppeteers of price.