There is a lot of talk surrounding the recent rise in bond yields (especially the 10-year Treasury). The media makes reference to a pending bond bear market. I thought it might be interesting to consider how bonds work and why the Great Bond Massacre might be overstated. Understanding how bonds work will help us make better, informed decisions as yields rise and the talk of bond bear markets continue.
How does investing in bonds work?
A simple way to look at bonds is that you are allowing someone (typically a company, agency or government) to borrow your money for a set period of time. They pay you a fee (interest) as an incentive to allow them to borrow the money. When the agreed upon time expires (matures), you receive your original loan back and collect the contracted fee while they were ‘using’ your money. We could make this much more complicated, but for now, let’s keep it simple. With this simplified model in place, let’s consider why yields change.
Why do bond yields change?
Consider the two sides of the bond transaction. Someone wants to borrow your money. You have money that can be ‘invested’ so you entertain their offer. But, you are not the only two looking to make a transaction. In fact, the global bond market is larger than the global stock market. This often surprises people and it means there is a lot of competition for bond dollars.
In this transaction, the borrower wants to pay the least amount of interest while the investor wants to earn the highest interest possible (all else equal). As conditions change, yields (and prices) change to reflect new information. There are many reasons bond values change, but I want to keep this as simple as possible and focus on today’s main point, so I will skip the lengthy explanation of the various components of bond pricing.
The simplest reason a bond yield (and price) changes is a shift in supply or demand. If demand increases, similar bonds may be able to lower what they pay in interest. If supply increases, the borrower may have to increase the interest paid.
Consider a scenario where nothing has changed other than the demand for interest payments. The increased demand potentially allows the borrower to lower the amount paid. Some of the increased demand may be willing to take a slightly lower interest payment, thus lowering the yield.
Now, consider a scenario where similar bonds provide higher interest opportunities. The investor will demand a higher interest payment given other options. The original borrower must offer a higher interest payment to entice investors, thus raising yields. Let’s walk through a more detailed example.
Why do bond prices go down?
Most have heard of the inverse relationship between a bond’s yield and its price. As yields go higher, the price of existing bonds price lower (we will skip new issues for now). Let’s consider the scenario above in which similar choices offer a higher yield. It is important to remember the terms (time and interest) do not change once agreed upon and the bond is issued.
Let’s consider the scenario in which we have rising interest rates. Today’s bonds offer higher interest rates based the current environment. Because the existing bond can’t change the interest rate, the adjustment made to make payments equivalent in real terms is via its price.
For example, assume a bond was issued two years ago. It paid 1% interest for 5 years. You could buy the bond for $1,000. Today, assume a similar three-year bond (same remaining time) offers 2% interest. If the original borrower wants to sell the initial bond, no one would buy it for $1,000 and give up 1% of annual interest for three years (we are ignoring term for simplicity). So, the market lowers the price to something lower, the lower price offsets the difference in interest payments. Thus, the inverse relationship.
Will rising bond yields create a bond bear market?
If all else remains constant, rising yields will lower bond prices. That creates a bond bear market. But, we need to consider the real impact of a bond bear market. A bond bear market is not the same as a stock bear market or at least it hasn’t been historically. Although the term bear market is used when either bonds or stocks fall, the historical impact is different…by a lot.
Reviewing the Great Bond Massacre
In January of 1994, the U.S. was emerging from a recession and enjoying the 34th straight month of economic expansion. The Dow Jones reached a new all time high. In the same month, a special council began investigation of President Clinton with respect to the Whitewater Development Corporation. The Fed Funds rate sat at 3%. The Fed was looking to contain inflation (high inflation of the 1980’s still remained forefront in people’s minds). Then Fed Chair Greenspan raised rates 6 times…doubling rates in just 12 months.
The Barclays (then Lehman) US Aggregate Bond Index lost 2.9% in 1994. Yes, you read that correctly…less than 3% and it was referred to as the Great Bond Massacre. You probably don’t need to be reminded of the returns of the great stock bear markets.
But it is different this time…
I paraphrased most of my summary from an article written by Angela Koch. You can click on the link at the end of the article to read more. If I hadn’t started with the year, you may have thought I was referring to the present.
The Fed has been on a steady path of tightening (but not at the pace of 1994). We have recently hit new all-time highs and yes, there is a special counsel reviewing a President’s action. If you choose to read the article, you will find the majority of bond loses were linked to corporate bonds (more on that later).
Times change, fundamentals don’t…
While writing this post, I am sharing texts with my friend Tracey. I know it…it shocks me too. It seems like only six months ago I was using a flip phone and couldn’t or wouldn’t text. Wait, it was only six months ago. Back to my point…
She is back east watching her daughter finish her collegiate softball career. We discussed how quickly time passes. She warned me of the upcoming ‘challenges’ as Steph enters her teenage years. Which brought me back to the point of the article.
Parents hear about the difficulty of the ‘teen years.’ The stories raise fear and anxiety. But, reviewing history helps put things back in perspective. In many cases, the fear of the ‘teen years’ turns out to be much worse than the actual event. I believe the reason is that fundamentals don’t change unless there is a significant shock to the system. I may be mistaken…reaching teen years may be a significant shock to the system.
Tracey would likely share that her daughter was for the most part a good kid. The changes in the human body during those years can make anyone crazy, but I think (and hope) a fundamentally good kid becomes a fundamentally good teenager and it sounds like…in her case, a fundamentally good young adult.
As people warn me of the ‘teen years’, I will focus on the fundamentals. Steph is fundamentally a good kid (with her moments). Of course, like most decisions…the rational side doesn’t always equal the emotional side. I will keep telling myself…Steph is a fundamentally good kid…when she challenges the status quo.
What is the status quo?
We know the Fed wants to and is raising interest rates. Current stock market valuations remain high. There remains political and global uncertainty. But, is it ‘really’ different this time? Have bond fundamentals changed? I would argue no.
Our status quo is to remain focused on your planning projections. They ground us during uncertain times. We consider current conditions and test what would happen if a past event repeated itself. Then we make informed decisions based on what we learn.
The bond massacre created over a trillion dollars in losses. Angela Koch discusses some of the biggest losers. The biggest losers were corporations who were likely highly leveraged.
As we return to the scenario earlier in the post, greater leverage typically means more risk. Greater risk should equate to a higher yield (you should be compensated for additional risk). When investors don’t properly measure risk, they assume the additional yield is free. They are wrong.
We focus on a more conservative bond allocation. Our goal when considering bonds is diversification and the desire to lower overall risk.
The media tends to sensationalize ‘facts’ to gain readers or viewers. Of course, it may be different this time, but for now, I will stick to fundamentals.
Angela Koch’s articleMark Duffel on Unsplash