Bond Bear Market: Why Investor Fears May Be Overblown
Should fixed income investors be afraid of a bond bear market? It’s a question a number of people have asked me recently.
Historically, bond bear markets tend to come and go relatively quickly, leaving investors who stayed in the fixed income market relieved they didn’t jump out. Nevertheless, because so many people have expressed fear of the current bond bear market, it may be useful to take a deeper dive into how various types of bonds have performed during bear markets. As we always say, past performance is no guarantee of future results, but perhaps a look back can be enlightening.
What is a bear market in bonds?
There is no consensus about what constitutes a bear market in bonds, although it can be thought of as a decline in prices (and rise in yields, which move inversely to prices) over time. Despite the long-term drop in bond yields from their peak in 1981 to the trough in 2016, there have been several bear markets along the way. For the purposes of this study, we chose four recent bear markets that were accompanied by Federal Reserve (Fed) monetary policy tightening, and then included the short, sharp rise in yields in 2013, otherwise known as the “taper tantrum.”1
We then looked at the cumulative total returns for various fixed income asset classes during those time periods. For the tightening cycles, we started with the month of the first rate hike, and ended with the month of the last rate hike. Here is a summary of the results:
Rising rate cycles—cumulative periodic return
Note: The cumulative periodic return includes automatic reinvestment of monthly distributions, net of fees. “N/A” used where data was not available. See “Important Disclosures” for description of the indexes used.
Source: Bloomberg, Morningstar Direct and Bloomberg Barclays. Cumulative total return is calculated for each indicated time period. Past performance is no guarantee of future results.
As you can see, there is no uniformity to the results, but there is a lot of green on the table. The 1994-95 cycle produced the weakest returns, although the heaviest losses were in long-term Treasuries with durations of 20 years or more and in emerging-market bonds. The market was caught off-guard by the Fed tightening in late 1994, especially the speed and magnitude of the rate hikes. The federal funds rate was doubled, from 3% to 6%, in about a year’s time, causing fallout in many parts of the market, especially leveraged sectors.
In the 1999-2000 cycle, the steepest losses were in preferred securities, developed-market international and high-yield bonds, while long-duration bonds produced positive returns. This cycle was milder and led to the bursting of the tech bubble in the stock market, which drove some investors into bonds as an alternative to stocks. Ten-year Treasury yields actually declined over the course of the cycle.
Flattening yield curves and tame inflation led to positive returns for bond investors in the 2004-06 cycle. The current cycle is showing similar trends. These longer, slower rate-hiking cycles that have been well-telegraphed to investors, and accompanied by low inflation globally, have produced strong results in the riskier parts of the market.
The Treasury yield curve tends to flatten when the Fed raises rates
Source: Bloomberg. 10-Year Treasury Constant Maturity Rate and Federal Funds Target Rate Mid Point of Range. Daily data for each rising rate cycle shown. One basis point is equal to 1/100th of 1%, or 0.01%, or 0.0001. Past performance is no guarantee of future results.
The 2013 taper tantrum was the exception. Yields rose sharply in a six-month time frame, with 10-year Treasury yields moving up by over 100 basis points. There was no tightening by the Fed, however, and consequently yields later retreated, producing positive returns for those who stayed invested. However, there was a lot of short-term damage to bond holders who chose to exit the market during the sell-off. It was a classic illustration of the impact of duration on returns in the bond market. Price declines were proportionate to the duration of the bonds.
Rising yields affect bond prices according to duration
Source: Source: Schwab Center for Financial Research and Federal Reserve, using yields as of 2/27/2018 This chart assumes a “parallel” upward shift in yields from current rates of 100 basis points, or one percentage point, meaning that rates would rise by one percentage point uniformly for Treasury bonds at each maturity. There is no single interest rate, and a rise in the short-term federal funds rate does not always result in a corresponding rise in longer-term Treasury rates. Duration is the weighted average term to maturity of the cash flows from a bond. Bond duration measures a bond’s price sensitivity to interest rate movements. Past performance is no guarantee of future results.
When it comes to credit-sensitive bonds however, there isn’t much consistency across cycles. For example, high-yield bond spreads versus Treasuries have risen sharply in some cycles, fallen sharply in others, and remained flat in a few.
The movement in high yield spreads has varied over each rate hike cycle
Source: Note: Option-adjusted spreads (OAS) are quoted as a fixed spread, or differential, over U.S. Treasury issues. OAS is a method used in calculating the relative value of a fixed income security containing an embedded option, such as a borrower's option to prepay a loan.
Source: Bloomberg Barclays, using monthly data of 1/31/2018. Shaded areas indicate rising rate cycles. Past performance is no guarantee of future results.
What we can say however, is that one way to mitigate risk in a rising-interest-rate environment has been to focus on relatively short-duration bonds that are high in credit quality. You won’t always outperform other fixed income asset classes, but you are less likely to get caught in a sharp downdraft. Moreover, adding some floating-rate paper when the Fed hikes rates historically has been beneficial.
Is this time different?
You might say that these examples aren’t helpful because:
This time is different, that it’s not just a Fed tightening cycle, but a long-term bear market.
The low in 10-year Treasury yields—1.35% reached in 2016—was probably a generational low, and yields could rise for years.
With the global economy recovering, and fiscal stimulus increasing the potential for inflation, and record government deficits for years to come, there is more risk of higher bond yields this time around.
I would agree—to some extent. The 2016 low will probably be the lowest yield we’ll see for many years, and the rise in debt/gross domestic product is likely to mean a big increase in the supply of bonds for the market to absorb, risking higher interest rates.
Nonetheless, a lot depends on the reaction of the Federal Reserve to these risks. If the Fed is too complacent and gets behind the curve on inflation, then it could mean an extended bear market with yields moving significantly higher than I anticipate. However, if the Fed’s rate hikes succeed in holding inflation in check, then the cyclical peak in yields could be reached in the first half of this year.
I lean toward the latter conclusion. The Fed appears to be moving the federal funds rate higher in anticipation of rising inflation stemming from a tightening labor market. Actual inflation is still low. That hasn’t stopped the Fed from raising rates, however, since the funds rate is still negative in real terms, and it will take two to three more rate hikes to “normalize” short-term rates. At that point, we’ll see how interest-rate-sensitive the economy has become after nearly a decade of very easy money policy. Housing, consumer credit growth and business loan demand are likely to slow somewhat as the cost of financing consumption increases. Given the high levels of leverage in the economy, it seems reasonable to assume that rising rates will slow economic growth over the course of the year.
The long-term view
It’s worth reiterating that even in a bear market, bonds can—and usually have—produced positive total returns. For instance, the 1954-1981 bond bear market, when the yield on five-year Treasuries rose from less than 2% in 1954 to more than 14% in 1981, is depicted in the chart below. The bars in the chart show the total return each year for a portfolio of Treasuries with five-year average duration.
Even in a bear market, bonds can produce positive returns
Source: The Schwab Center for Financial Research with data provided by Morningstar, Inc. Shown in the chart are the yield-to-worst and annual returns including price change and income for the Ibbotson U.S. Intermediate-Term Government Bond Index. Past performance is no guarantee of future results.
As you can see, if an investor had held a portfolio of high-quality bonds of short to intermediate duration, and held that duration constant over the years, the total return in most years would have been positive.
Why? Because bonds generate income. Over the 1954-1981 time frame, the rise in yields increased the income component of the return, offsetting price declines most of the time. In fact, as yields rose the income component grew. That’s why there are only a handful of years in which returns were negative, and those were very modest declines.
¹ “Taper tantrum” is the term used to refer to the 2013 surge in U.S. Treasury yields, which resulted from the Federal Reserve’s announcement that it would begin to taper the bond-buying program with which it was then injecting money into the economy. In reaction to the news, investors drew money rapidly out of the bond market, which sharply increased bond yields.
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