Despite continued fearful cries from naysayers over the past several years, the bond market hasn’t experienced the catastrophe that many continue to anticipate. But while there is no disputing the fact that we are in the final inning of a 30+ year bull run that has seen Treasury bond yields drop from the mid teens to practically zero (see below chart), predictions for an imminent, far flung bond market disaster continue to be a bit, well, far fetched in my opinion.
10 Year Treasury Yield
Historically speaking, there have been many widely accepted stock market bubbles, including the “Nifty-Fifty” episode in the early 1970s and more recently the “dot com” technology/Internet bubble of the late 1990s. In each of these cases, many equities dropped more than 50% in value. If the definition of a bubble is a capital loss of 50%, then what would have to happen in the bond market in order to generate such a disastrous loss for investors? For illustration purposes, we’ll take up a specific example.
Let’s say that tomorrow we buy a newly issued bond at par with a 13 year maturity and 4.75% coupon that computes to a duration of roughly ten years. An important measure of bond sensitivity to interest rates, one of the things duration tells us is how much the value of our bond might drop given a rising rate scenario – for every one percent move in rates, a bond’s price moves inversely by the current measured duration. So for our 13 year bond a 1 percent (100 basis point) move in rates would equate to a 10% decline in value. Thus we would require an immediate 500 basis point move in rates to generate a paper loss of 50 percent on this bond.
While an upwards move of 500 basis points is certainly within the realm of possible, it will not happen overnight – and would, in all likelihood, take many years to occur. And as each year that a bond is held, barring unusual circumstances, duration decreases. So hypothetically if rates rose 100 basis points per year for five straight years, our bond would actually lose less than 50 percent of its paper value. Further, unlike some of the “dot com bombs” from the late 90s in which investors lost ALL of their capital, we are still guaranteed our principal back at maturity. So even if rates rise 1000 basis points over the next 13 years and we see the value of our bond plummet to “bubble” territory, eventually its value will return to par as it approaches maturity in 2026, barring a default.
The longer the duration of the bond, the quicker a “bubble” loss might occur, and thus the inherent “opportunity cost” danger of owning long-term bonds in rising interest rate scenarios. But just like stock investors who see the value of their investments wax and wane over time, I suppose even long-term bond investors who continually buy long-term paper may be little phased by rate gyrations as long as there is no interruption of interest payments.
If rates were to rise quickly and swiftly from this juncture, historians could potentially point to the existence of a 2013 bond bubble, especially if we consider the potential hit that long-term bond pricing could take. However, given current macroeconomic realities and a Fed that seems to continually delay the likelihood of a protracted tightening bias, I’m inclined to think that this seemingly final inning could turn into a surprisingly protracted rain delay for bond bears and bubble blowers.
Still, near zero rate policy, the threat of higher yields, and opportunity cost associated with being “long and wrong” should give tactical bond investors reason for pause. For that reason, I would skew a portfolio toward the short end, as there appears little reward and plenty of potential risk for going out on the curve. Thus, while I think bond investors should be extremely cautious of how much maturity risk they are willing to shoulder, they shouldn’t necessarily be frightened away by a doomsday scenario that may or may not ultimately come to fruition.
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About the author:
Adam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.