Bond yields have surged from record lows reached in 2016, raising fears that a long-term bear market may have begun.
While the low in yields for this cycle is likely behind us, it’s too early to declare the start of a prolonged bear market.
Whether it’s a short-term or long-term bear market, reducing duration in fixed income portfolios and paying close attention to credit quality may help mitigate potential volatility.
Bond yields have spiked since last summer, raising concerns about a long-term bear market. But declaring a bear market for bonds is more challenging than it is for stocks.
Unlike the stock market where a 20% drop in prices is considered the marker of a bear market, there is no consensus about what constitutes a bear market in bonds. Perhaps that’s because bond yields have been in a secular, or long-term, bull market since September 1981, when 10-year Treasury yields hit 15.8%. Within that 35-year downtrend, however, there have been at least nine periods when yields rose substantially—that is, by more than 100 basis points or at least 25% from starting levels.
To distinguish between temporary spikes and actual bear markets, we think it’s reasonable to define a bear market in bonds as a sustained decline in prices (or rise in yields, which move inversely to prices) during a period of tighter monetary policy from the Federal Reserve. By that definition, there have been four cyclical, or short-term, bond bear markets over the past 25 years, including the so-called “taper tantrum” in 2013-2014 when Treasury yields surged as the Federal Reserve suggested it would gradually cut back on its bond-buying program.
Short-term bond bear markets have occurred a few times over the past 25 years
Ten-year Treasury yield, 1993-present
Notes: Shaded areas indicate rising rate cycles: Feb '94 - Feb '95, Jun '99 to May '00, Jun '04-Jun '06, May '13 to Dec '13 (taper tantrum), and Dec '15 to present. Circles indicate bond bear markets, which are defined as a sustained decline in price (or rise in yield) over time combined with tighter monetary policy from the Federal Reserve. Past performance is no guarantee of future results.
Source: Bloomberg. 10-Year Treasury Constant Maturity Rate (USGG10YR). Monthly data as of 1/17/17.
The latest increase in yields represents a fifth cyclical bear market. The Fed began tightening in December 2015 when it raised the federal funds rate for the first time in nearly a decade, and bond yields have moved up by more than 100 basis points from last summer’s record lows. And given that the 1.36% yield on 10-year Treasury yields hit last summer was the lowest in modern history, that could very well have been a generational low.
2017 outlook: more sideways than up
Our outlook for 2017 calls for yields to increase at a slower pace. We believe 10-year Treasury yields could rise to the 2.75% to 3.0% range and expect the Fed to raise interest rates at least twice. Bond yields have moved up from last year’s lows in anticipation of stronger economic growth and higher inflation due to potential tax cuts, increased government spending on infrastructure and deregulation. These policy changes could arrive during a period of near full employment and rising wages.
However, for every policy move that provides stimulus, another could slow the economy and affect our outlook. Protectionist trade policies could lead to retaliation by our largest trading partners and reduce U.S. exports, slowing overall growth. Similarly, tax reform that includes a border tariff could send the dollar higher. Repealing the Affordable Care Act could be negative for growth in employment in the health care sector, the fastest growing segment of the job market. While deregulation and spending on infrastructure should be positives, it’s likely to take time to implement those policies with the boost to employment and gross domestic product growth not showing up until 2018 or beyond. Moreover, the Fed is already in the process of tightening monetary policy and will likely increase the pace of tightening if inflation expectations increase.
What does a bear market in bonds look like?
Bond bear markets are not all alike. About the only common characteristic of the past five cyclical bear markets is rising interest rates. The pace and magnitude of rate increases varied. In each cycle, the yield curve peaked before the Fed finished hiking short-term rates, though the timing of the peak varied. In the 1990s, the yield curve peak occurred several months after the Fed began to raise short-term rates, while in the more recent cycle, the peak was much earlier.
The performance of credit-sensitive bonds also varied widely prior to and after the first rate hike. In some, the yield spread between corporate bonds and Treasury bonds was flat or declined. In others, it increased quite substantially.
Corporate bonds’ reaction to an initial rate increase has varied
Bloomberg Barclays U.S. Corporate Bond Index, yield spread performance
Barclays U.S. Corporate High-Yield Bond Index, yield spread performance
Option-adjusted spreads (OAS) are quoted as a fixed spread, or differential, over U.S. Treasury issues. OAS is a method used in calculating the relative value of a fixed income security containing an embedded option, such as a borrower's option to prepay a loan.
Source: Bloomberg Barclays data as of 1/9/2017.
A secular bear market isn’t as scary as it sounds
To find an example of a secular bear market in bonds, we had to go back to the 1950s. From 1954 to 1981, 10-year Treasury yields moved up to over 14.85% from a low of 2.35% as the economy pulled out of a recession. However, yields didn’t move up in a straight line. After an initial jump to 3.5% in 1955 as the economy recovered, yields stayed in a range from 3.5% to 4.5% for the next decade even though the economy grew at an average rate of about 6% in nominal terms. Yields didn’t begin to accelerate higher until the 1970s when the U.S. ended the dollar’s ties to gold prices, government spending and deficits increased and inflation had begun to move up sharply.
If an investor purchased a 30-year bond in 1954 and held it to maturity, she would have experienced a significant price decline and missed out on the opportunity to earn more income. She may have sold the bond at a loss somewhere along the way. However, a different strategy with shorter duration and the flexibility to reinvest could have produced better results.
In the chart below, the annual total returns for an index of intermediate-term government bonds during that time period are depicted by the blue bars. Returns were actually positive in most years. Think of the blue bars as the total return (price change plus coupon income), much as you would the annual return on the S&P 500® index. It’s counterintuitive, but since all income is positive, rising rates produced rising income. In most years, the income helped offset the price decline. The key is to limit duration and maintain the ability to reinvest interest income as yields rise.
Even in bond bear markets, negative returns are rare
Annual total return for intermediate-term government bonds, 1954-1981
Source: The Schwab Center for Financial Research with data provided by Morningstar, Inc. Shown in the chart are the yield-to-worst and annual returns including price change and income for the Ibbotson U.S. Intermediate-Term Government Bond Index. Indices are unmanaged, do not incur fees or expenses, and cannot invested in directly. Indices are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly. Past performance is no guarantee of future results.
What’s a bond investor to do?
Amid all the uncertainty about policy, and with no consistent historical pattern to market behavior during bear markets, the prospect of holding bonds during a bear market can look unsettling. At a minimum, we think that volatility in the bond market will be high in 2017. However, steps can be taken that may help mitigate the impact of increased volatility and higher interest rates.
First, reduce the duration in your portfolio. Bonds with shorter durations tend to be less volatile when interest rates move up (a Schwab bond specialist can help you determine the duration of your bonds or fixed income holdings). To estimate the impact of rising rates on a bond, look at the bond’s duration. A bond with a duration of five years typically will move down in price by about 5% for every 100-basis-point increase in interest rates. A bond with a 2-year duration typically will move down by about 2%.
Interest rates can affect bond prices
Change in Treasury price based on 1% rise in rates
Source: Schwab Center for Financial Research and Federal Reserve, using yields as of 1/17/2017. This chart assumes a "parallel" upward shift in yields from current rates by 1%, meaning that rates would rise 1% uniformly for Treasury bonds at each maturity. There is no single interest rate, and a rise in the short-term Fed Funds rate does not always result in a corresponding rise in longer-term Treasury rates. Duration is the weighted average term to maturity of the cash flows from a bond. Bond duration measures a bond’s price sensitivity to interest rate movements.
You might want to consider adding floating rate notes that tend to benefit from an increase in short-term interest rates; however, they usually carry lower yields than fixed notes of the same maturity.
Second, look carefully at credit quality. A growing economy is often good for corporate bonds because company earnings and ability to pay interest expenses are improved. However, there isn’t a set pattern for the behavior of credit during cycles of rising interest rates. We believe it makes sense to be somewhat cautious because valuations are on the high end of historical averages.
Finally, try to focus on your financial plan and the reasons that you hold fixed income investments. For example, they can be a counterbalance to riskier investments like stocks, and can help you manage volatility over time. Fixed income investments also can provide steady, predictable cash flows, making them a useful source of income in a portfolio.