What a Bursting Bond Bubble Looks Like
October 16, 2012
In the simplest terms, people tend to be motivated by two competing passions: greed and paranoia. When times are good, economists say that our interest-maximizing caveman brains urge us to try and get our hands on as large a slice of the resource pie as possible. However, when fortunes turn and times get tough, paranoia sets in as we try to protect every last scrap of what we’ve gained. It is this eternal psychological battle between gains and losses, risks and rewards that shapes the markets we trade.
It’s also why so much is made of talking about risk compared to return, and it’s here that there has always been a demand for safe havens – places where people feel confident in the return OF their capital. And when it comes to safety in the last 30+ years, bonds have definitely been tough to beat. The long decline in rates (and corresponding increase in bond prices) has cemented the appearance of safety and stability. The current bond bull market has been underway for so long, it’s easy to forget that it hasn’t always been this way.
While we’re usually preoccupied with the Treasury bond bubble, our friends over at Welton Investment Corp. recently released an excellent paper as part of their Visual Insight series (click here to view the full piece) focusing on the corporate bond bubble. Like us, they’ve been wondering what the future holds for this “safe” refuge. In reality, that veneer of security is like the surface of a still pond… filled with piranhas. You see, bonds have historically had what Sean Kelly of The Samples called, “a dark side.” Just like the song, everything can be perfect and happy, right up until disaster strikes and a more somber note takes effect. Hand-wringing over our economic future is definitely not new – but in light of Welton’s work, now seems like the perfect time to look beneath the placid surface – to see what those murky depths contain.
But before getting to bond’s dark side, first a look at the bright side. You see, the world of high-quality corporate bond yields looks much the same as government bonds over the past 80 years: all-time high yields in 1981, followed by a 30+ year decline in yields (and a corresponding 30+ year bull market in corporate bonds). Yes, we know it is confusing – but that downwards sloping orange line on the graph represents a bull market for bonds (that whole rates down/prices up thing). For most of those managing money these days, all they have ever known has been a bull market in bonds, be they corporate or treasury (rates lower, prices up). But take a look at the left side of the chart, and what happened in the 30 years following the great depression and its corresponding huge levels of government debt and record low yields. Yes, it can happen – rising interest rates.
In light of this history and the seemingly forgotten fact that interest rates can rise, Welton’s paper sets out to explain that bonds are anything but safe during periods of rising interest rates. In fact, even the safest, highest quality AAA rated corporate bonds have had some rather big drawdowns – definitely not the hallmark of an investment that’s supposed to keep your assets protected. Welton examined every period in which interest rates for the Moody’s Seasoned AAA Corporate Bond Yield rose by more than 1.5%, and calculated the drawdown experienced by bondholders for each. We recreated their findings in the table below, sorting them by worst drawdown period (data courtesy of Welton Investment Corporation Visual Insight Series):
The scary part of this data set is not just the depth of bond drawdowns. After all, -24% isn’t that scary when compared to stocks, commodities, real estate, etc. where each have had drawdowns over -50%. Higher volatility asset classes are definitely “riskier” in the sense that they’ve undergone much larger declines. But even so, I doubt most investors are thinking their ‘safe’ bond portfolio can lose over 25% of its value.
The bigger takeaway from this chart in our opinion isn’t necessarily the magnitude of the bond drawdowns – it’s the duration. As the table shows, prior to 1981, corporate bonds have had several multi-year long drawdowns, including 7 year span in the 1960s when bond investors were underwater. While those seem like ancient history to most given we’ve witnessed smaller, shorter drawdowns over the past 25 years… just because a risk is out of sight doesn’t mean it should be out of mind.
Bond Drawdowns = Principal Loss, Less Coupon Payment
Now of course, a decline in the value of your bond holdings doesn’t necessarily mean you’ll take a loss – as there is always income coming in via the coupon payment, or the original interest that the bond issuer pays in exchange for an investor lending the issuer money. Unlike managed futures, hedge funds, and many stocks; bond investors earn a fixed amount of return each year from this ‘coupon payment’, so even if bonds drop in price and they lose principal, they will still get some money back from the coupon payment.
This would seem like good news for bond investors, and it is in a way. But it can also act as a double edged sword when rates are low. Welton shows that low rate environments (like the one we’re in right now) tend to result in worse drawdowns, both in magnitude and duration, because there is so little revenue coming in via the coupon to offset the loss of principal. They then have a nice graphic (they always have the nicest graphs over there) showing how a bond DD works, overlaying the price drawdown (red) on the coupon income (blue) to arrive at the drawdown amount (orange):
Source: Welton Investment Corporation Visual Insight Series
Knowing what has happened in the past is always a help, but as Yoda would say, “Always in motion, the future is.” The real trick is figuring out how things might unfold in the future given the current rate levels. One way of approaching this is asking what sort of drawdowns could bond investors be looking at if rates rise at different levels from here. Using the drawdown model illustrated above, Welton looks at several possible scenarios moving forward, starting with a look at the same moves that happened in the past happening from the current rate levels, and then exploring what happens if the future holds even more severe increases in interest rates.
We have recreated their findings in the table below, and see that most of the scenarios for the bond bubble bursting are none so bright for bond investors, with the average drawdown being -24% and 36 months. (Data courtesy of Welton Investment Corporation Visual Insight Series)
How many investors holding the highest-rated corporate bonds are ready for a -35% drawdown and three years of being underwater? How many pensions and other institutional portfolios relying on that income and safety of that part of the portfolio could withstand that long? We’re guessing not a whole lot… Looking at all of this added together, it’s hard not to jump to the conclusion that the next bubble is here, and it is in bonds! Of course, we’re not the first people to say that, and it’s worth noting that most of those who have been calling for such have been wrong for the better part of three years now. But it is becoming part of the narrative as can be seen below:
And one contrarian view: John Bogle Says It’s Impossible to Have a Bond Market Bubble
What it Means for Managed Futures
The message here, of course, is don’t be blind to the risks of your bond portfolio just because there hasn’t been a hint of drawdown in the past 30 years. The risks are real, they are there, and they will come again. But the bigger message, and why you’ll find managed futures firms like Welton and ourselves espousing bonds – is that managed futures aren’t just stock market crisis period performers – they are apt to do well in a bond crisis period as well.
Of course, this is where things get difficult, though – because we don’t have managed futures data back to the 1960’s when the last bear market in bonds happened. So we can’t show you the crisis period performance of bonds during most of the rate increase periods. The two periods there is managed futures index performance for show managed futures posting gains of about 2% from Sep 1993 to Nov. 1994 when AAA bond investors experienced a drawdown of -10% and a gain of about 0.50% from Dec 1998 to May of 2000 when AAA bond investors saw a drawdown of -8%. [Disclaimer: Past performance is not necessarily indicative of future results, managed futures performance via the BarclayHedge CTA Index]
But we don’t need to rely on past performance here. Indeed, it is good practice to not rely on such. What we can say is that managed futures are apt to do well during a bond "crisis period" because of how they approach the bond market. We wrote why managed futures love bonds in a 2011 newsletter, and those lessons apply to this discussion.
You see, when it comes to managed futures, they love bonds because:
1. There are a lot of bond futures markets and a lot of people trading them, making for good volume and liquidity
2. They’re affordable, from a risk management perspective – with the average range times contract value about half that of stock indices and energies
3. They tend to trend (as we’ve seen in the charts above)
4. They are in backwardation (this item could cease to be a tailwind in a rising rate environment).
So it isn’t a problem for managed futures that they have done well in bonds with rates falling, and a bond bubble bursting would mean rates rising; because the factors driving bond performance in managed futures aren’t based on the direction – they are based on the risk/reward of the trades and fact that the markets tend to trend a bit more based on macro economic factors.
At the same time – there is a LOT more room for bonds to trend down (rates up) than there is for bonds to continuing going up. And for that reason we believe a sustained period of rising rates (and a corresponding downward trend in bond prices) would be huge for managed futures performance. In fact, we’ve been anxiously awaiting just such a scenario for a while now.
There’s no way to really know what’s going to come next, but it’s certainly worth contemplating. The consequences of a bursting bond bubble could be severe, and the further inflated the bubble becomes, the more exacerbated said impacts become. Either way, the next year or so will be a sight to behold - is your portfolio ready?
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IMPORTANT RISK DISCLOSURE
Futures based investments are often complex and can carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading losses are material points which can adversely affect investor returns.
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