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Are we going through a 'bond market rout'?

The second half of 2016 is shaping up as one of the more negative half years for bond returns on record, especially at the long end of the yield curve.  It’s not uncommon for financial press articles to refer to what’s happening to government bonds as a 'rout', but is it really that bad?

The focus of this article is the US Treasury market, bond yields, and what that means for bond returns.

Since early July 2016, when 10-year Treasury yields traded at an all-time low of 1.36%, the trend has been higher. It was a steady burn for a few months, but the speed of the increase has picked up since early November. This was around the time financial markets started to price in a Trump victory, a few days out from the vote.

As of 9 December, an investor could purchase a 10-year Treasury to yield 2.47%. Of the 1.11% increase over the past five months, around 2/3 has happened over the past four weeks, and an increase of 0.77% over a month is a very sharp move by historical standards; not unprecedented, but far from common.

The following chart shows the history of the 10-year US bond yield since the all-time peak back in 1983. Since then, there have been 10 prior periods (shown by the arrows) where the yield has increased by at least 0.9% over around 5-6 months.

In other words, history tells us we can expect a long bond yield rise of the magnitude we’ve seen in 2016 on average once every three years.

Of course, this rising trend may not yet be over. The 1.11% rise posted so far could turn into more, so what does history tell us in this regard?

History repeats, but how often?

Not surprisingly, history does not provide much clarity. Even if there were a regular pattern, a sample size of 10 is nowhere near enough to draw firm conclusions. However, there isn’t a regular pattern. Half of the previous 10 occurrences of at least 0.9% increases petered out around this level. If those histories are repeated, then this ‘rout’ is just about done and dusted.

The other half, however, continued for varying lengths and to varying degrees. If these histories were to repeat, then there’s a way to go yet before we reach the peak in this cycle for US yields. The following table summarises those episodes.

The impact on bond prices and bond returns

Of course, when bond yields rise, bond prices fall, at least initially (every bond matures at par, whatever happens today or tomorrow). When the time period over which this happens is short enough, total bond returns can become negative as well.

The recent yield increase translates into a decline in the capital value of the 10-year Treasury bond since early July of 10.0%. Here we have a living, breathing instance of the usual example that’s used to explain what 'modified duration' means. That is, if you get a yield move of 1% you multiply the duration to get the price change. In this case the yield move was a little bit more than 1%, but with the modified duration of the current 10-year bond at around 9.2 years, the maths follows.

Adding back the interest that’s been paid and accrued, the total return on the bond over the past five months has been -9.4%.

To compare this with history, it’s easier to use data for a bond index, such as the Bank of America Merrill Lynch 10-15 year Treasury index. The total return on this index over the past five months has been -8.6%. This ranks as the third worst return over a similar period in the past three decades. It was outdone only by 2013’s ‘taper tantrum’ of -9.9% and the -9.1% from the yield rebound in 2009 that followed the Lehman collapse.

The reason a yield move that has already occurred 10 times has resulted in a total return among the worst few in history is mostly because of the starting yield. When 10-year bonds have risen by about 1% in the past, they’ve been paying 4%, 6% or higher interest returns. That provided a larger positive contribution to the total return over any five-month period than July 2016’s 1.4% yield. Low yields also mean longer bond duration, which magnifies the impact of a given yield change. For instance, in a 6% yield environment, the 10-year bond’s duration would have been around 7.5 years instead of more than nine years. So a 1% yield change today means an additional 1.5% in capital value adjustment.

What does this mean for Australian bond investors?

Most Australians hold a portfolio that is more of a composite of domestic government, semi-government and corporate bonds. Their portfolio at July’s low point was yielding 2% and has seen an increase to around 2.6%. That’s a much more moderate change than has taken place in the 10-year Treasury market. Also, the local market has a significantly shorter duration of about 5.3 years. Therefore, broad Australian bond market indexes over the past five months have returned a much more moderate -3% or thereabouts.

Furthermore, the one-year returns for 2016 will be positive. The broad market index seems likely to come in at around +3%, so still above cash. This is because the sell-off in the second half of 2016 followed a rally in the first half of the year.

End of the bull market?

What we’ve witnessed over the past few months could well mark the end of the so-called '30-year bull market in bonds'. The possibility that yields will continue to trend higher, back to pre-GFC levels where 10-year Treasuries paid investors 4% or more, is not objectionable. It would be fantastic if that happened, because it would mean that world economic fundamentals had healed, after being so badly damaged in the last decade or so. It would mean that bond markets were experiencing rising returns – short term capital pain, yes, but rising reinvestment into a higher-yielding environment that will produce better long-term outcomes than the low yields we’ve seen during 2016.

However, it’s still far too early to call the end of the 'lower-for-longer' scenario. Just because bond yields have risen from their all-time lows doesn’t mean they’ve broken out of the historically low trading ranges of the past few years. They might do that, but they haven’t yet.

 

Warren Bird is Executive Director of Uniting Financial Services, a division of the Uniting Church (NSW & ACT). He has 30 years’ experience in fixed income investing. He also serves as an Independent Member of the GESB Investment Committee.

 

6 Comments
Warren Bird
June 15, 2022

OK, I guess it's time for an update. I could now clearly add a new row to the table in the article of significant periods of rising yields (aka "bear markets"). I might be a few basis points out given the data I now rely upon, but over the last 2 years, since July 2020, US 10 year yields have risen from 0.55% to 3.43%. That's 2.88% over 23 months. So in yield change terms, it's up there with 1994 - a tiny bit worse at this stage in fact - but it's played out over quite a bit longer period. Total returns over this period have been much lower than in 1994, however, given the lack of yield to maturity at the start of the current bear market. We're looking at negative returns over the 2 year period for the typical Australian bond fund of 10-15%, with the more recent 12 months within that two years contributing more than half of that outcome. 1994 wasn't quite as bad and it was only the one year before returns recovered due both to high starting yields (over 10% in Australia) and a peak in the yield cycle. (That was, as it turned out, the last opportunity to buy Australian government bonds at double digit yield. Not many fund managers took that chance, but I'm happy to say that the funds I had control of at the time did move quite a bit from cash to bonds at the time.) It's not necessarily over yet, of course, so the record bear market move in the US of 3.25% in 1987 is well within reach and could easily be exceeded. The lunacy of central banks ignoring how their QE had turned into money supply growth in 2020-21, resulting in them not acting to contain inflation a year ago when it was obvious that it was going to be an issue, means that even at 3.4%, the US 10 year Treasury bond is paying a big negative real yield at the moment. But it's not as negative as cash, so I expect that the big end of town will start to nibble at buying bonds and lengthening duration from here. Cautiously, I suspect, but if the central banks do start acting to reign in their monetary policy accommodation and get us back to a more slow and steady with inflation, then from a longer term perspective yields are just about at 'fair value' levels.

Warren Bird
March 09, 2021

Ah, it's happening again, with articles like today's AFR piece on the 'bloodbath' we're supposedly experiencing now. The article is about Australian long bonds, which have risen a bit further than in the US and a little more sharply than over there, but to update the data in this article what we've seen (so far) is a 7 month 'bear market' in which 10 year Treasury yields have risen by 1%, from 0.55 to 1.55 since last August. That's mild by comparison with the 1999, 2008-09 and 2013 bear markets which were of similar duration.
This one could go on a bit longer, of course, but it's far too early in my view to be looking at the current market as anything other than just a normal period of cyclical change in bond yields.

Warren Bird
January 14, 2020

I think we can now definitively say that the 'bear market' that started in July 2013 ended a little while ago, in October 2018. 


Thus we can update the table in the article, changing the bottom line to show a total yield increase from trough to peak of 1.65% and the time period for this move at 27 months.

So, the mildest 'bear market' in US Treasuries ever and it took a relative eternity to play out. Like I said in the article, this was not a rout!

We can say that the period of rising yields ended October 2018 because they've since fallen below 2% again.

Warren Bird
January 31, 2018

With many articles in the last week or so seeking to get everyone excited or worried or panicky about the latest move up in US (and global) government bond yields, I'm reminded of this article which I wrote just over a year ago.

Although since then yields initially fell (as noted in the comments above) and are now on the rise again, you could consider the current move to be a continuation of the shift to higher yields that started in July 2016. If you look at it that way, then this is the longest period of bear market in the history covered in the paper (back to 1983), at 19 months. But it is also the mildest (so far) with a total net move up of under 140 bps. The total return over this 19 month period from the BoAML US Treasury Master is pretty modest, at -3.6%.

Analyst and media commentator hype is now focusing on how the yield has now broken to its highest in 4 years and that sort of thing. So what? The long run trend (since 1983) to lower nominal yields ended back in 2012. Since then 10 year Treasuries have traded in a range from around 1.4% to 3.0%. We're still in that range.

My concluding paragraphs from Dec 2016 therefore still stand. We may be a little closer to seeing a higher risk free return on capital from a healthier world economy, and with it a higher long term rate. But for me that's a reason to celebrate, not a reason for concern.

Warren Bird
April 13, 2017

Update: US 10 year Treasuries last night traded down to a yield of 2.24%. Since the sharp rise post-election, the market had traded in a 2.30-2.60% range. So last night represents a break out from that range, on the side of lower yields.

Yet again those who want to get bearish on the bond market are being thwarted by the reality that the risk free return on assets in the global economy continues to be very low. Just when you think it's safe to start backing risk again, the economy falters or global tensions erupt and we are reminded of the threats that financial assets actually face.

I continue to wish it weren't so and that the world could sustain a move to higher interest rates. Just don't think we're quite there yet.

Warren Bird
December 21, 2016

Looks like the RBA Board came to a similar conclusion, though if they'd held the meeting a week or so later (the time I wrote this article) they might have been a little more alert to the possibility that this current move could turn into one of the larger moves seen in recent decades. Quote from the minutes of the December meeting released yesterday:

Members observed that the increase in US Treasury yields, while large, was not as large as some other movements in recent decades and yields remained very low by historical standards.

 

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