I’ll admit this week’s column started in a rabbit hole. I was reading about the bond market and rates, since there’s so much discussion about them right now. Specifically, the news that the 10-year Treasury yield just posted its biggest quarterly jump since 1994. That caught my eye, and somewhere along the way I came across a story I’d never heard before and ended up spending more time on it than I’d planned. It has a county treasurer (the “Wizard”), a borrowed fortune, an accountant everyone called Chicken Little, and, for good measure, a psychic. It also turns out to be the clearest explanation I’ve found for what’s happening in bonds right now.
We’re Off to See the Wizard
In the early 1990s, Orange County, California, was best known for beaches, Disneyland, and a lot of money. And a man named Bob Citron was quietly managing a large share of that money as the county’s longtime treasurer. Now, Citron wasn’t a Wall Street type. He was a career county employee with no college degree or formal investment background, and he’d been re-elected so many times the job had practically become his name.
He was also, by every visible measure, brilliant. Citron ran an investment pool of roughly $7.5 billion on behalf of the county, its cities, its school districts, and its water and sanitation districts. Year after year, he beat the comparable state-run pool by a couple percentage points. In public finance, where the goal is usually “don’t lose anything,” that’s like hitting .400 with 60+ home runs (ode to playoff baseball). The local press took to calling him a financial wizard, and some towns were so impressed they borrowed money just to put it in his pool and capture the difference.
But what most of those admirers didn’t fully appreciate was how he was doing it. Citron had made one big, simple bet: interest rates would stay low or keep falling. Then he made the fatal mistake: he borrowed against the pool’s holdings to buy more bonds (we’ve talked about the risks of leverage before), stretching about $7.5 billion into a portfolio that controlled roughly $20.5 billion. Through 1993, with rates near multi-decade lows, the strategy looked infallible. That’s the thing about one-way bets: they always look like genius right up until the moment they don’t.
Chicken Little Was Right
In 1994, Citron faced a challenger for his position as county treasurer. John Moorlach, a private CPA and financial planner, had read the county’s investment reports and didn’t like what he saw. He campaigned on a concept that, at the time, sounded too academic for the common voter: interest rate risk. If rates rose, he argued, the investment returns would evaporate, and the borrowed money would turn losses into disaster.
The response was dismissive, as local officials (including plenty of fiscally conservative ones who should have been his natural allies) derided him as Chicken Little. Why would anyone want to mess with a treasurer who was making everyone money? Citron won re-election in June.
The problem was that the sky was already starting to fall. On February 4, 1994, the Federal Reserve raised rates by a quarter point, its first increase in five years. Markets were caught flat-footed. The Fed kept going, hiking six times that year and taking short-term rates from 3% to 5.5%. The 10-year Treasury yield, which had bottomed around 5.2% in the fall of 1993, climbed above 8% by November. Bond investors worldwide took enormous losses in what became known as the Great Bond Massacre.
For Orange County, the math caught up fast as the firms that had lent Citron money demanded more collateral, which he didn’t have. On December 6, 1994, Orange County filed for bankruptcy after losing about $1.6 billion, the largest municipal bankruptcy in U.S. history at the time. The county cut more than 1,000 jobs and roughly $200 million came out of the budget. And in an interesting twist of fate, Moorlach himself was appointed to clean up the mess.
And then came the detail that makes this story unforgettable. A grand jury later found that, as things began to unravel, the man running a multibillion-dollar bond portfolio had relied on a mail-order astrologer and a psychic for his interest-rate forecasts. You can’t make this stuff up.
The $40 Problem
So how does a “safe” bond portfolio bankrupt one of America’s wealthiest counties? It comes down to a relationship that trips up many investors: when interest rates rise, bond prices fall. But this inverse relationship makes more sense when you see it in action.
Say you pay $1,000 for a bond that pays you $40 a year. That’s a 4% yield. Now rates rise, and newly issued bonds pay $50 a year for the same $1,000. If you try to sell your bond, no rational buyer will give you $1,000 for $40 a year when they can get $50 elsewhere. Your payment is fixed, so the only thing that can adjust is the price. Your bond has to fall in value until it offers a buyer roughly the same deal as the new ones.
And time makes this worse. If your bond matures next year, you’re only stuck with the below-market payment for a few months, so the discount is small. If it matures in 30 years, you’re stuck for three decades, and the price drop is much larger. That sensitivity to time is what professionals call duration. For most investors, a one-year bond in a rising-rate world is a minor inconvenience, while a 30-year bond can be a real problem.
For a typical bondholder in 1994, this meant a painful but survivable year. Citron’s problem was the combination of borrowed money and rising rates. By stretching $7.5 billion into $20.5 billion, he owned nearly $3 of bonds for every $1 of actual savings. A single-digit drop in bond prices, multiplied by that leverage, wiped out about a fifth of the pool. Ordinary bond math plus borrowed money equals bankruptcy.
1994, Take Two?
Which brings us back to why I fell into this rabbit hole in the first place. The bond market just finished its roughest stretch in three decades. The 10-year Treasury yield touched 5.34% last week, its highest level since 2002, surpassing its 2007 peak. It rose about 0.87 percentage points during the third quarter alone, the sharpest quarterly increase since, you guessed it, 1994. A year ago, that same yield sat around 4.1%.
The causes are familiar to anyone following the news: an oil shock tied to the war in the Middle East, inflation that refuses to cool (the Fed’s preferred measure was running at 3.4%), and a federal government that needs to borrow a staggering amount of money. The Fed raised rates in September for the first time since 2023, and the minutes released this week showed most officials expect to do it again before year-end. Futures markets currently put the odds of a December hike above 80%.
Plug that into the $40 problem, and the effect is very real. As a rough rule of thumb, a 10-year Treasury bought at the start of the quarter lost something like 7% of its market value in three months, and that’s not what anyone expects from the “boring” side of the portfolio.
Buying the $50 Bond
Here’s the part of the story that gets lost in the headlines. Every bond market selloff has two sides. For the person holding the old $40 bond, rising rates are a loss. For the person with new money to put to work, rising rates mean they can finally buy the $50 bond. Ten-year Treasuries now yield more than they have in nearly a quarter century, and investors are starting to notice.
That doesn’t mean rates have peaked. Nobody knows that, astrologer or otherwise. Wall Street’s track record on calling rate turns is only slightly better than Citron’s psychic. It means the questions worth asking are the ones Moorlach was asking in 1994. What are your bonds there to do? Are they meant to provide stable income, cushion a stock market decline, or cover a known expense in a few years? How long are you locked in?
The sky doesn’t fall on everyone. It falls on the people who bet everything that it never would. Moorlach wasn’t predicting the weather; he was simply pointing out that nobody had checked the roof.
Markets / Economy
- Markets remain a bit confused, with higher rates and tensions in the Middle East. The S&P finished the week up 1.2%, the Nasdaq up 0.6%, and the small-cap Russell 2000 down -0.9%.
- The average 30-year fixed mortgage rate jumped another 19 basis points to 7.49% in the week ended October 2, following an 18-basis-point increase the previous week and reaching its highest level since late November 2023.
- The University of Michigan’s consumer sentiment index fell to 46.3 in early October, according to the preliminary estimate, its lowest level since May’s record low and well below market expectations of 47.6.
Stocks
- U.S. equities were in positive territory. Utilities and Consumer Staples were the top performers, while Technology and Industrials lagged. Value stocks led growth stocks, and large caps beat small caps.
- International equities closed lower for the week. Developed markets fared better than emerging markets.
Bonds
- The 10-year Treasury bond yield decreased four basis points to 5.24% during the week.
- Global bond markets were in positive territory this week.
- High-yield bonds led for the week, followed by corporate bonds and government bonds.
