Why bonds collapsed and what you can do about it
by Raul Elizalde - 2016-11-15
The result of last week’s election made some Americans happy and others miserable. Given how high emotions are running, it is remarkable that voter participation was so low: Almost 47% of voters did not show up to choose the next president. Many people, it seems, were indifferent. Not so the bond market.
Take the US 10-year note, for example: in the week from 11/4 through 11/14 it climbed 44 basis points, from 1.78% to 2.22%. This is the largest move in relative terms since the New York Fed started publishing data in 1962. Because prices and interest rates moved in opposite direction, bonds crashed.
The size of this change is hard to overstate. It dragged bonds around the world: the German 10-year bond rate surged 45 basis points from -0.13% to 0.32%, for example. The UK’s 10-year bond rose by an astonishing 78 basis points, from 0.64% to 1.42%.
These moves wiped out trillions of dollars of savings allocated to fixed income. Wealth destruction is probably more brutal in Europe and Japan, where individual savers and institutional investors rely far more heavily than Americans on fixed-income products.
Why did bonds suffered this much?
President-in-waiting Trump has said during the campaign that, under certain circumstances, he would be willing to renegotiate the US debt, which would be a repudiation of the “full faith and credit of the United States.” This is exceedingly unlikely to happen, both because he would be unleashing a catastrophe and because the legal hurdles are too steep. But he said it, and it affects perception.
Many economists expect that the combination of large tax cuts and public infrastructure spending promised by Donald Trump would increase the size of the US debt by trillions of dollars, even after accounting for the potential growth generated by the stimulus. We don’t know yet whether this is in fact the plan of the new administration. If it is, and economists are right, it will also weaken the credit quality of US Treasuries.
Inflation expectations have gone up, partly because of the possible stimulus mentioned above. Ten-year expected inflation (calculated from TIPs) climbed 20 basis points, from 1.68% on 11/4 to 1.88% on 11/11. In part, this is a consequence of the possible stimulus discussed above.
Whatever the reasons, the market appears convinced that rates are heading higher, and Investors who are still exposed to long-duration Treasuries need to look at ways of transitioning out of them.
Unfortunately, the precipitous and historical magnitude of the recent move raises the question of whether to cut losses now or to wait for some kind of “relief rally” providing a better exit point.
The problem is that rates are universally expected to climb. Therefore, the majority of investors are likely to be waiting for the same exit point, which gets in the way of it happening at all.
Another problem is that when the Fed started raising or lowering rates in the past, it almost never stopped at one or two hikes. The higher-rate path that started last December is likely to be a multi-hike trail. This will push bond rates higher still.
Investors are exposed to bonds in two ways. One is by holding individual bonds, which is not the worse option because the scheduled payments take place independent of market conditions. Another is through mutual bond funds, which unlike individual bonds are at the mercy of rising rates and have no guaranteed schedule of payments. Unfortunately, individual investors are far more likely to hold bond funds than individual bonds.
The larger issue is that fixed income, up to now an integral part of investment portfolios, may no longer be the best asset class to diversify equity exposure.
The well-known “60/40” strategy that calls for a mix of 60% in stocks and 40% in bonds worked very well for the last 35 years of declining interest rates. But, if rates have bottomed out and start to climb in earnest, bond funds could be a significant drag on portfolio performance. This is especially so in the early stages of rate increases, when higher interest payments are not enough to offset losses of principal. To make matters worse, interest rate trends are measured in decades, not years. Once they start, it’s anybody’s guess when they will end.
Investors needing diversification may have to change their approach. One is through cash, which simply muffles equity returns. Another, which we advocate, is by abandoning the idea that a static diversification such as the “60/40” is appropriate for all market conditions. A better way, in our view, is to become considerably more active in asset allocation. We have developed specific processes to implement such active strategies.
In the last few years, investors were told many times that interest rates were heading higher only to see they go lower. It’s still early to say whether we have finally reached the turning point. But the new era that the United States is entering could finally get us there. If so, investors will need to change the way they diversify their portfolios going forward.
We believe that our portfolio management process, focused on measuring and managing risk, can be very effective at creating a sensible balance between risk and return. We implement this process for our clients and we tailor it for their specific circumstances. We can also help you evaluate your current goals and establish an investment plan aiming at steady, long-term returns while managing downside risk. Please send us a request for a copy of our most recent whitepaper describing our investment methods and goals, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success. Read more