Potential for a loss unlike any other for bonds

5 min read

A bond market unprecedented in history means investors face the risk of potentially unprecedented losses.

That’s a big deal, not just because it’s not unreasonable to think about a 10% loss, or drawdown, in global sovereign debt values, but because this is the asset class which is supposed to provide stability. It is a bit like having your house burned down by faulty wiring in your smoke alarm.

Also sobering is the fact that it is hard to construct a scenario in which bonds sell off this rapidly and other financial assets also do well.

Fitch Ratings published a study this week finding that if global sovereign bond yields revert just to where they were in 2011, investors would suffer losses of as much as US$3.8trn, a bit more than 10% of the US$37.7trn in outstanding debt from the largest 50 investment grade issuers.

“As rates hit record lows, investors face growing interest-rate risk. A hypothetical rapid rate-rise scenario sheds light on the potential market risk faced by investors with high-quality sovereign bonds in their portfolios,” according to Fitch.

Median yields on 10-year notes are 270bp lower than they were in July 2011, while median yields on one-year securities have fallen by 176bp. Losses would vary based on how far interest rates have fallen, with bonds in the eurozone states like Spain and Italy losing 21% of their value, according to Fitch.

None of this is to say a rapid return to the interest-rate structure of even five years ago is likely. Indeed, policy-makers and investors are now preoccupied with the opposite issue of how to prevent inflation and yields from falling further.

A 10% drawdown on global bond portfolios, however, is something we’ve not seen in the past 30 years. Since 1986, the worst year suffered by government bond investors is a relatively small loss of 3.1% in 1994, according to data from M&G Investments, with 1999 and 2013 also slightly negative years.

Of course, investors tend to have a home bias in their bond portfolios, so a global reading will not give a picture of how the losses will actually be handed out. The worst US Treasury drawdown in recent memory was in 1980 when 10-year notes lost 16% of their value as Fed Chair Paul Volcker waged his successful fight against inflation by hiking interest rates sharply. Looking at long-dated US Treasuries as a whole the worst year was 1931, with a 9% loss.

It is different this time

Looking at history as a guide may do little good, given that with global interest rates at unprecedentedly low levels, we’ve never had a comparable experience. More than US$10trn of global debt is now at negative yields, meaning that it costs investors to hold, rather than paying.

That means that the typical portfolio of government debt is not throwing off the kind of income we’ve seen in past sell-offs. In January of 1980, the beginning of the worst year for 10-year US notes, they were yielding 10.8%. US 10-year notes now yield 1.54%.

“The reason that total returns have rarely been negative is because investors were receiving relatively high coupons and had a significant income cushion to protect against any capital downside,” Anthony Doyle of M&G wrote in a 2015 study of the issue.

“These days, total returns in government bond markets will largely be a function of capital movements, with income providing little support in a bear market for government bonds.”

One possibility is that if global bonds began to sell off there would be much less of the kind of natural support they’ve enjoyed in the past, with some investors willing to hold them to maturity and accept the coupon in compensation. While an insurance company might be reluctant to take the loss to capital of selling very low-yielding bonds in a bear market, at a certain point many will feel that holding debt which is declining in value for 10 years for a percent and a half a year in income is a bad deal.

And again, we are only here talking about returning to the status quo of 2011, hardly a “normal” year in terms of interest rate structure.

Investors may dislike the recovery in growth and inflation, if ever it comes, even more than they did the current great stagnation.

(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)

James Saft