How Bad Could Bond Market Losses Get?

Financial advisor Ric Edelman gave Howard Gold at MarketWatch some pretty sobering thoughts on the bond market this past week:

“The typical investor today has never experienced a sustained rising-rate environment and they are emotionally and historically unprepared for what happens when interest rates go up 3% or 5%,” he said in a telephone interview this week.

Millions of Americans, he observed, “are engaging in a variety of risky behaviors, often without knowing what they’re doing. They’re setting themselves up to lose a lot of money over the next several years, perhaps as much as they lost in 2008 in stocks.”

“You could see 20%, 30%, 40% losses in the bond market over the next several years,” he continued, “and the people who are most exposed to it are retirees trying to live on their income. The people who are the least able to handle it financially are the ones most likely to suffer.”

Edelman runs one of the largest independent financial advisory firms in the country, so this isn’t simply a pundit spouting off.

The question is: could we see 2008-like losses in the bond market?

First of all, you have to define the types of bonds we’re even talking about here. Edelman says that many investors have piled into long-term bonds and high yield debt because they come with higher yields. High yield bonds have only been around since the 1980s, so they’ve never really experienced a sustained rising rate environment.

We can, however, look back at the performance of various treasury bonds to see how they performed in the last real bond bear market.

Before we get to that, there’s something that many investors forget when discussing the implications from rising rates on bond returns. Namely, that higher yields are eventually a good thing for your bottom line.

A few years ago Vanguard performed a study to see how the Barclays Aggregate Bond Index would be affected by an overnight 3% rise in interest rates (something that has never actually occurred). They calculated what would happen if rates suddenly rose from 2.1% to 5.1% and showed the impact going out 5 years:

screen-shot-2016-11-17-at-1-19-36-pm

You can see the immediate loss would be around 13% (they also noted that the worst 12 month loss ever in bonds was -13.9% in 1974). But because the yield on bonds would now be much higher, the expected return going forward would now be around 5.1% annually, meaning the breakeven would be just over 3 years. So not exactly a crash of epic proportions.

While anything is possible in the markets, it would take something crazy to have interest rates rise 3% or so this quickly. Historically, rates have risen much more methodically. I looked back at the historical interest rates for 5 year treasuries, 10 year treasuries and 20+ year treasuries to see how they have performed during past rising rate environments. Here are some examples for each maturity level:

screen-shot-2016-11-18-at-10-58-16-am

I found instances where rates rose anywhere from 2%+ to 5%+ and calculated the total returns during those time frames. Long-term bonds saw the worst returns during these periods, which makes sense given their higher duration (thus higher volatility and magnitude of loss).

These returns weren’t anything to write home about, but they never saw huge crashes, mainly because the biggest threat during the 1950s to 1980s bond bear market was inflation, not rising interest rates. It also helped that the pain was spread out over a number of years and didn’t happen all at once.

In fact, if you look at the returns on 10 year treasuries from the time yields bottomed in the early-1940s until they peaked in the early-1980s, the drawdowns were all fairly mild. In the 40 years or so, the average annual loss was just -2.10%. Here’s the entire list of losses:

screen-shot-2016-11-18-at-12-50-17-pm

A few additional thoughts:

  • Rates could definitely move higher much faster today than they did in the past, simply because news and information flows much more quickly these days.
  • In my opinion, higher inflation is a much bigger risk than rising interest rates when it comes to bond performance. Inflation and rates would likely move up together and for the same reasons, but unless we see a huge, short-term shift up in rates I’m guessing we won’t see any 2008-sized losses in high quality bonds.
  • If rates do rise, high duration, low credit quality and long maturity bonds will get dinged the most. As always, it’s important to know why you own bonds in the first place and understand their risk/reward profile. All bonds are not created equal.
  • I’m amazed at the number of people who are certain rates are going to see a sustained rise. It could happen, but you would think people would have learned their lesson about the difficulty of predicting interest rate movements over the past 5-10 years that has seen nearly everyone get it wrong.
  • A bad year in the high quality, intermediate maturity bonds is typically the same as a bad day or week in the stock market.
  • Some investors may choose to avoid bonds altogether and just hold cash and stocks in a barbell approach. The problem here is when do you get back into bonds? What if you’re wrong on rates?

Planning for fixed income assets is not as easy as it once was…

Sources:
Bond-market losses may hit 40%, and retirees are most vulnerable (MarketWatch)
Risk of loss: Should the prospect of rising rates push investors to high quality bonds? (Vanguard)

Further Reading:
Do Stocks Diversify Bonds?

 

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  • Clark Herring

    Through my 401K I can invest in a roduct called a stable value fund. It is a contact with insurance companies. for the last three years it has yielded a fairly stable 2.2%. There are no capital gains or losses associated with this product. It has been around for over 30+ years. I recognize the counter party risks. Are there other risks that I should consider? I tend to view this as an alternative to money market funds and not bond funds. The yield is net of fees. I have spoken with the person that manages our companies 401k and they agree with my representation above.

    • Ben

      Good question. A few things to consider:

      -what are the underlying holdings?
      -what’s the purpose of the holding? bond substitute? cash substitute?
      -what are the fees to the provider on this fund (usually make a decent amount)?

      • Clark Herring

        From my discussion with the 401k manager I believe the underlying holdings are bonds – primarily US treasuries I believe but may be mistaken about this. Again we get return from teh fund but no capital risk. yes I cannot figure out how they do it either. back in 1982 this fund yielded 17% (not a typo). It did not get below 10% until 1990. From my portfolio perspective I look at this as a Money market substitute but also as a place holder for bonds. This comprised 31% of my portfolio with 5% cash 7% Vanguard REIT Index and the rest a split between Vanguard S&P 500, Vanguard International index funds and biotechnology funds. I have asked the question about fees for the stable value fund and they are included in the yield that i see. The yield is an after cost yield. The 401K if from a Fortune 500 company and they are focused on fees for the 401K. I have been personal friends with the 401K manager aka Pension manager for 25+ years. This person has been in this job since 2003. They follow the same investment strategy that I do low cost index funds re-balanced to maintain the appropriate asset allocation. Are there any other questions I should be asking this person?

        • Ben

          I would be curious how they did in 2007 & 2008 b/c that’s when a lot of funds got into stuff they shouldn’t have. a good check would be to look at the maturity, duration and yield on something like the AGG or BND ETFs. understanding credit quality standards is a big one too

          • Clark Herring

            Below are the rolling 12 month yields by month from 1/1/2007 to 1/1/2010, I look at my portfolio one a month. using a 12 month average smoothes out the particular day that I choose and the number of says in a month. Post 2009 the interest rated perked up slightly before decling.
            1/1/2007 4.9%
            2/1/2007 4.9%
            3/1/2007 4.9%
            4/1/2007 4.9%
            5/1/2007 5.0%
            6/1/2007 5.0%
            7/1/2007 5.0%
            8/1/2007 5.0%
            9/1/2007 5.0%
            10/1/2007 5.0%
            11/1/2007 5.0%
            12/1/2007 5.0%
            1/1/2008 5.0%
            2/1/2008 5.0%
            3/1/2008 4.6%
            4/1/2008 5.0%
            5/1/2008 5.0%
            6/1/2008 4.9%
            7/1/2008 4.9%
            8/1/2008 4.9%
            9/1/2008 4.8%
            10/1/2008 4.7%
            11/1/2008 4.7%
            12/1/2008 4.6%
            1/1/2009 4.6%
            2/1/2009 4.4%
            3/1/2009 4.7%
            4/1/2009 4.2%
            5/1/2009 4.0%
            6/1/2009 3.9%
            7/1/2009 3.8%
            8/1/2009 3.7%
            9/1/2009 3.7%
            10/1/2009 3.7%
            11/1/2009 3.7%
            12/1/2009 3.7%

    • bill

      If this product is from an insurance company, I’d guess that some of the fund is in commercial real estate mortgages.

      • Clark Herring

        Bill this is an insurance company product. I will ask the question what the products is invested in . I thought mostly high quality bonds.

        • Clark Herring

          From the prospectus their are four types of contracts of which only three are used SYNs 90%, STIFs 4% and SAGICS 6%. They are defined below. The expense ratio is 0.33%
          Synthetic Guaranteed Investment
          Contracts (SYNs)
          Each SYN investment consists of: (1) a portfolio
          of fixed income securities (for example, U.S.
          government and agency securities, mortgagebacked
          securities, asset-backed securities, and
          corporate bonds) that are owned by the SVF
          and (2) a type of stable value contract called a
          “wrapper contract,” which is issued by a bank,
          insurance company, or other financial institution
          (the wrapper issuer) and is specifically tied to the
          underlying portfolio of fixed income securities.
          A SYN’s “crediting rate” is the rate at which
          interest is earned by the SYN, and it is defined
          by the wrapper contract. The crediting rate can
          be variable or fixed. A variable crediting rate
          is designed to recognize over time the effect
          that changes in market interest rates have
          on the underlying portfolio of fixed income
          securities and the changes in the underlying
          securities themselves because of active
          portfolio management. A variable crediting
          rate is recalculated on a periodic basis, usually
          monthly. Because of the smoothing effect of
          the crediting rate calculation, the return to a
          variable-rate SYN will be less volatile than the
          return to that SYN’s underlying portfolio of
          fixed income securities.
          Guaranteed Investment Contracts (GICs)
          and Bank Investment Contracts (BICs)
          GICs are investments made with insurance
          companies that typically provide a fixed rate
          of return for a specified time period. The
          amount invested becomes a part of the
          insurance company’s general assets, which
          are invested as the insurance company deems
          appropriate, without guidance or control
          from the SVF investment manager or from
          ConocoPhillips. BICs are the same type of
          investment but are made with a bank rather
          than an insurance company
          Separate Account GICs (SAGICs)
          SAGICs are another insurance company
          investment product. The key difference
          between a GIC and an SAGIC is that SAGICs
          are backed by fixed income securities, which
          are held in an account separate from the
          insurance company’s general account assets.
          The crediting rate paid on a SAGIC can either
          be fixed or variable. The variable crediting rate
          is calculated in generally the same way as it is
          on SYNs (see above). Although the securities
          are owned by the insurance company, the SVF
          investment manager provides guidelines for
          managing them.
          Short-Term Investment Fund (STIF)
          A small percentage of the SVF is kept in a STIF,
          which is similar to a money market fund, to
          provide cash for daily trading by participants.

          • economicminor

            Since 2010 commercial real estate construction has gone nuts. Shopping centers and new box stores all over. Not counting apartment complexes. All this while the middle class’s income has been flat to stagnant..

            The only reason was because every retail box was looking to expand their market share and could due to low rates. This is mal investment. The bonds behind this will eventually fail unless some miracle happens to the incomes of the middle class.

            All this was supported by ignoring risk and lending to people and institutions who, unless something very positive happened to their incomes, the loans were never going to be fully repaid.

          • cfbcfb

            I don’t know if your area is like mine but we’ve also had a boom in commercial RE. Most of it sits empty. One large office/retail mall built near the end of the last big CRE boom just slid into foreclosure. Over the last ~15 years I don’t think even 20% of it was occupied at any given time.

          • economicminor

            Here in S Ore our regional mall is about 2/3 occupied. There was a Sports Authority that recently went under and 3 nice sized local businesses dealing in outdoor equipment. Since the recession an REI, a Dicks, an Outdoor Warehouse, a Field and Stream have opened and I understand Cabella’s is to also open a store. This without any huge increase in population. This is just the sporting goods arena. I go to Portland regularly and the number of apartment complexes being built is astounding. Reminds me of the Mediterranean coast in 2006/7.

  • For bond funds, one should pay particular attention to asset backed securities. Those may have been purchased in an attempt to increase current yield, but may involve other difficult-to-analyze risks that may become a problem in a rising rate environment.

    One should also be careful about bond funds that have used leverage to increase yields. The leverage could amplify the downside.

    Nick de Peyster
    http://undervaluedstocks.info/

    • Unless the collateral type is weird (subprime, Man Housing) or has operating characteristics — e.g., Franchise Loan ABS, or odd structures it is tough for AAA ABS securities to lose principal.

      • economicminor

        yeah, who is rating them? With what model or matrix? Seems like we just went down this road and very little has changed. Almost no one alive has seen deflation or an asset/bond bubble of this size. Good luck with your assumptions.

  • MG

    I think a key sentence is “the biggest threat during the 1950s to 1980s bond bear market was inflation, not rising interest rates,” so I would be interested to know how much worse your second table would look when it is inflation adjusted. That is, in addition to Total Returns you list Real Total Returns. Otherwise you are kind of comparing apples and oranges since the different periods experienced different inflation, which impacts the real losses to investors.

    • Ben
      • MG

        Thanks for this reference. Wow, including inflation certainly alters the outlook, when the total return on bonds from 1950-1981 was 144.3%, but when adjusted for inflation the real total return was -37.4%. “Death by a thousand cuts” indeed!

    • economicminor

      except this time it isn’t inflation it will be the collapse of the underlying asset value..
      No way to have inflation when 80% or more of the consumers are already stretched to the max with debt and lousy paying jobs.

  • RobS

    It’s a bit hard to imagine 20-40% losses in quality bonds; even over a few years as Ric describes. One thing I’d wonder is “what are other nations in the world doing at this time?” Given the interconnectedness of financial markets, if Germany is offering a 1% bond, but the USA treasury yields suddenly went to 7%, it seems like someone might hedge out the exchange rate risk and still make a good bit of money on the US bond.

    When things are close, the FX costs might not make sense (likely a wash over time, so the cost must be considered — hedge when cheap, ignore when expensive). But it’s hard to imagine we could see that dramatic of a disparity and not have even more buyers of Treasury debt. We do now, so it’s hard to imagine it would all suddenly dry up.

    Are those countries moving trillions back home to invest in their home market yields when they’re below zero? Finding the “bigger fool” after a move like that would be hard.

    • Ben

      The one caveat here would be long-term gov’t bonds. for example, TLT down -21.8% in 2009

      • RobS

        Very true. The year before, TLT +33% so rotation back into stocks was probably the biggest reason for that big drop.

        But even over a full market cycle, your point is valid I think –> I mean, TLT has done quite well over the last few years so a big gyration to the downside could come.

        Personally, I think it’s a bit high.

        • Michael

          “a big gyration to the downside could come”

          It’s already down over 15% since the July high.

  • tedfeely

    This is a very timely article. Thank you.
    I’m looking at FLEXSHARES IBOXX 5 YEAR TARGET DURATION TIPS INDEX FUND (TDTF) which is an ETF.

    My goal is to diversify a portfolio that I hope will be 50% equities and 50% counter-equities (that is, behave contrary to Equities but not necessarily the opposite of equities. To give you a flavor of the counter-equities, I’m holding USDU (a dollar currency ETF), IAU (a small amount of Gold) and BKLN (PowerShares Senior Loan Portfolio Fund) an ETF that invests in senior floating rate relatively short-term notes offered by BBB rated or lower companies. I will dump any of the holdings if they fall below my trading criteria so I’m not so concerned about long-term losses as I am intermediate term losses.

    Back to TDTF: I like it because it’s based on a 5 year target date (providing some duration protection and some opportunity for maturity rollover assuming I hold it that long) and owns TIPS (Treasury Inflation Protected Securities). The TIPS part of it should behave very well (really?) if inflation is in the driver’s seat, but maybe not so well if inflation is low, but interest rates are rising. I’m a real novice when it comes to TIPS (although I’m painfully experienced in holding mutual fund bond funds long term from about 1975 through the late 1970’s – it felt terrible and I was way out of my depth at that time – maybe still am).

    Any thoughts? Concerns? Hidden gotchas? Your comments will be appreciated.

  • A 40% loss over 3 years means you owned only 30-year bonds at 3%, and rates went to 7% and stayed there. A 40% loss on a 10-year note over 3 years means 7-year rates went to 14%.

    This would be far from a normal bond bear market, particularly in the recessionary conditions we are in, with very low monetary velocity.

    As an aside, Hoisington put out a note saying that it is all going to reverse, and they are the ones who have ridden this long bull market so well.

    • Ben

      Yeah, I also think people underestimate the potential rush to safety should things get crazy in the stock market.

  • Richard Russell

    “and the people who are most exposed to it are retirees trying to live on their income. The people who are the least able to handle it financially are the ones most likely to suffer.”

    This makes no sense, surely if a retiree is trying to live on the income from their savings then they are desperate for interest rates to rise!

    • Ben

      Right, and the fact that those income payments will still be coming in. It’s the principal that’s affected.

  • bubba123

    If you buy a bond at 3% coupon, and interest rates go up, sure the bond “price” may drop. But if you hold to maturity, you earn your 3%. This is the fundamental reason to invest in bonds, not to trade on price increases/decreases. As a bond investor you accept credit risk, inflation risk (depending on maturity), and get compensated for it. The inflation risk is usually built into a coupon, and no market will offer a bond paying 3% in an inflation is running at 10%.

    The second issue I have with the above, is in the Vanguard study, whereby the insinuate that the total return increases if interest rates rise. This is based on the assumption that you re-invest your coupons at the higher prevailing interest rate. Which in reality is never going to be possible, and even if it is, you may not want to. Take for instance you have $100,000 and you buy a 10-year treasury today at 2%. You will earn $2,000 a year for 10 years. If interest rates rise this year to 3%. Are you really going to invest your coupon of $2,000 at 3% to earn $60 each year for another 10 years.
    I very much doubt it.

    • cfbcfb

      If inflation rises to 3-5% (or more) are you still going to want to hang onto that 3% bond?

  • economicminor

    http://wolfstreet.com/2016/11/21/online-lending-fiasco-credit-bubble-peak/

    Wolf Richter has a good primer on where we are at presently.

    When everyone is on one side of a trade and runs to the other side, the boat can capsize.. What I mean is that as all the bonds issued have counter parties and as risk is always real in a system, the apparent absence of risk does not eliminate it. So, if we are at the top of a bond bubble (which would make a lot of sense), then as it pops, Three things are going to happen. One is that as the losses start appearing people will want to get out of them. This will drive up the interest rates.. Two, there will be few new buyers because once interest rates start to rise, the asset value of them declines. So who will want to purchase a declining asset class. The third pressure is that when bonds start to collapse, people who use them as collateral will also have to sell. This will become a self reinforcing cycle where the higher rates go, the more selling and the higher they go.

    The world has never seen such.

    It is the greatest fear of the FED because then its balance sheet gets decimated. Yet they are already in a pinch as there aren’t a lot of good quality bonds or securities left to purchase. And as they take off the market the better quality securities in a time of declining corporate revenues, this in itself can drive up interest rates.

    • bill

      This is one reason why the Fed should be shrinking its balance sheet instead of paying higher IOR.

  • cfbcfb

    Anyone that didn’t get out of bonds a few years ago is a few cents short of a nickle.

    What’s more disturbing than having most investors with no experience involving a real positive interest rate is that most money managers don’t have that experience either. So they’re going by the book and plowing a large % of your money into bonds. Cuz “You’re supposed to”.

    I’m holding 3 years in cash, rest in equities. I’ve been that way since 2007.