Market Commentary | April 14, 2021

How to Handle a Bond Bear Market

It can be challenging to handle a bond bear market, a period during which investors drive bond prices down and yields—which move inversely to prices—higher. The good news is that the worst of this phase of the bond bear market may be over, and you can take steps to help mitigate the impact of increased volatility and higher interest rates.

In considering how to handle a bond bear market, it may be useful to remember the opening lines of Anna Karenina, in which Leo Tolstoy wrote, “Happy families are all alike; each unhappy family is unhappy in its own way.” Think of bond bear markets as the unhappy families that periodically send yields up amid the long “happy” downtrend in interest rates over the past 40 years. While the bond market has been in a secular1 bull market characterized by a series of lower highs and lower lows in yields, it hasn’t always been a smooth trend. Like Tolstoy’s unhappy families, the handful of periods of rising rates that interrupted that trend each had different causes and characteristics.

What is a bond bear market?

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. We consider it a significant rise in the 10-year Treasury yield of at least 100 basis points (one basis point is equal to 1/100th of 1%, or 0.01%). By that definition, the U.S. Treasury market has entered the sixth bear market in modern history. Since the low of about 0.50% last August, 10-year Treasury yields have risen by about 125 basis points to 1.75%.

There have been several bond bear markets within the overall secular bull market

Since 1990, there have been six occasions when the 10-year Treasury yield rose at least 100 basis points.

Source: Bloomberg. U.S. 10 Year Treasury Yield. (USGG10 Index). Daily data as of 4/7/2021. Past performance is no guarantee of future results. 

 

While each has been different, this one really stands out as unique. No other cycle in modern history has been characterized by a sudden, pandemic-driven stop in economic activity leading to massive fiscal and monetary support, followed by a sharp recovery. Most bear markets in the past have been the result of an overheating economy with rising inflation, prompting tightening monetary policy by the Federal Reserve. This time around, the Fed has pledged to keep its policy easy in an effort to ensure a strong recovery and higher inflation.

Yields may pause for now

The good news is that the worst of this phase of the bond bear market may be over. The unprecedented policy response to the COVID-19 crisis likely means that this bear market will be shorter and steeper than those of the past. Moreover, much of the news driving yields higher already appears to be discounted. The market is already pricing in Fed rate hikes beginning in the second half of 2022—more than a year earlier than the time frame projected by the Fed. Long-term yields have returned to pre-pandemic levels and inflation expectations are already at or above the Fed’s target range of 2% to 2.5%—as you can see in the chart below showing the current breakeven rate for Treasury Inflation Protected Securities (TIPS)—even though actual inflation readings remain subdued.

TIPS breakeven rates are above the Fed’s 2% inflation target

​   ​Five-year breakeven inflation expectations are at 2.58%, and 10-year breakeven inflation expectations are at 2.34%.

Note: Breakeven inflation is the difference between the nominal yield on a fixed-rate investment and the real yield (fixed spread) on an inflation-linked investment of similar maturity and credit quality.
Source: Bloomberg, Daily rates as of 4/7/2021

 

The Fed versus the market

Based on Eurodollar futures rates, investors expect the Fed to begin raising the federal funds rate in 2022.

Source: Bloomberg. The market estimate of the federal funds target rate using Eurodollar futures. The term Eurodollar refers to U.S. dollar-denominated deposits at foreign banks or at the overseas branches of American banks. The 12/15/2027 Eurodollar futures rate was used for the longer-run market rate. As of 4/7/2021.

Nonetheless, we see room for yields to continue rising as the economic recovery progresses but expect the pace of increase to be slower. A further rapid rise in yields would likely require more upside surprises in the economic and inflation data from already elevated expectations. Another limiting factor for yields is the wide spread between U.S. bond yields and those in other major developed countries. Even after currency hedging costs, U.S. yields are high relative to most yields in Europe and Japan, which are near zero. At more than 80 basis points on a currency-adjusted basis, demand for U.S. Treasuries from foreign investors should increase. Until growth in Europe and Japan improves, 10-year Treasury yields may stay below 2%.

U.S. Treasury yields are higher than those of other major developed countries

The U.S. 10-year Treasury bond yield is currently 1.65%, while the Japanese 10-year bond yield is -0.13 and the German yield is -33%.

Source: Bloomberg. Data as of 4/7/2021. Past performance is no guarantee of future results.

 

For the balance of 2021, we look for 10-year Treasury yields to move higher, most likely to the 2% to 2.5% region. Our fair value model indicates that yields in the 2% region are reasonable in the short run.

Ten-year Treasury yields have the potential to rise as high as 2.5% this year

 

Our fair value model shows a range as high as 2.5%.

Source: Bloomberg. 10 Year Treasury Yield and a Proprietary Multifactor Fair Value Estimate of the 10 year Treasury, using JPMorgan Global Manufacturing PMIs, Inflation Swaps, and the Term Premium. (USGG10YR Index, MPMIGLMA Index,  FWISUS55 Index, ACMTP10 Index). Using monthly data as of 3/31/2021. Past performance is no guarantee of future results

 

Yields in the 2% to 2.5% range are consistent with the Fed’s long-run target for the federal funds rate. In past cycles, 10-year yields have peaked near the peak in the fed funds rate. As of the March meeting, the FOMC’s median estimate of the longer-run fed funds rate was 2.5%.

Long-term view: Fiscal and monetary policy changes could mean higher yields

We are nonetheless cautious about the potential for even higher yields longer term, due to the shift in monetary and fiscal policies that is taking place. The Fed’s patient stance, encouraging higher inflation, could keep upward pressure on yields. It has indicated a willingness to tolerate inflation overshooting its 2% target for as long as a year. Consequently, bond investors may require more compensation for the risk of inflation in the future.

Fiscal policy, meanwhile, has become far more expansive than it has been in decades, which means the likelihood of higher deficits that need to be funded with more issuance of Treasuries. On the plus side, investments in infrastructure and education could lift productivity and the economy’s potential growth rate. That would mean that stronger gross domestic product growth wouldn’t necessarily be inflationary. However, to the degree that fiscal and monetary policies are designed to lift incomes of middle- to lower-income households, the demand side of the economy could be stronger than it has been for many years. Stronger real growth would likely translate into higher real yields.

The first Fed rate hike is an important signal

Bear markets in bonds typically end when the Fed has squashed inflation concerns and the pace of economic growth begins to slow. In recent cycles, the bulk of the increase in long-term bond yields has occurred prior to the Fed’s initial rate hike. This pattern differs from cycles in the 1980s and early 1990s. We attribute it to the Fed’s adoption of a more transparent communications strategy in May 1999. With more clarity about where policy is headed, the market has been able to adjust expectations more quickly. Since that change, 10-year Treasury yields have declined or stayed flat after the start of the Fed tightening in every cycle.

Change in 10-year Treasury yield relative to first rate hike

In 1999, 2004 and 2017 rate-hike cycles, the 10-year Treasury yield declined or remained relatively flat in the weeks following the first rate hikes.

Source: Bloomberg. U.S. Generic 10-year Treasury Yield (USGG10YR INDEX), using weekly data for the specified time periods. Past performance is no guarantee of future results.

 

While there are a lot of concerns about the Fed’s ability to control bond yields longer term under its new framework, we don’t see that as a big problem. The Fed could shift its bond purchases towards longer-term bonds and/or increase its bond purchases, targeting the higher maturities. It could engage in “yield curve control” where it designates a target yield for long-term bonds and commits to buying whatever quantity of bonds it would take to maintain that yield.

We don’t see the Fed taking any of these actions any time soon. However, in our view the most effective way for the Fed to limit the rise in long-term yields would likely be to start raising short-term rates. That would signal its intention to reduce or limit inflation. We don’t see that happening this year however, so the risk is still to the upside in yields.

Historical perspective: Making money in a bond bear market

Given our view that the 0.5% yield for 10-year Treasury bonds reached last year is likely to stand as the lowest reading for many years and there is potential for higher yields ahead, we looked back at how the market behaved during the last long term bear market.

To find an example of a secular bear market in bonds, we had to go back to the 1950s. From 1954 to 1981, five-year Treasury yields moved up to over 14% from below 2% 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 1956 as the economy recovered, yields stayed in a tight range 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 (a strategy we generally would not recommend) 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, or 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

 

During 28 bond bear markets dating back to 1954, annual total returns were negative in only five of them.

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. Past performance is no guarantee of future results.

 

What’s a bond investor to do?

The prospect of holding bonds during a bear market can look unsettling. However, steps can be taken that may help mitigate the impact of increased volatility and higher interest rates.

1. Reduce duration. First, if you haven’t already done so, reduce the duration in your portfolio. Bonds with shorter durations tend to be less volatile when interest rates move up. 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

A 1% rise in rates could cause a 2% decline in 2-year bond prices, a 9% decline in 10-year bond prices, and a 22% decline in 30-year bond prices.

Source: Schwab Center for Financial Research with data from Bloomberg. Durations as of 4/14/2021. 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 federal 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. Prices are hypothetical and provided for illustrative purposes only.

 

2. Consider bond ladders. Bond ladders can be a useful in a rising yield environment, especially one with a steep yield curve. Spreading bond maturities out over time allows investors to capture more income as yields rise. Instead of trying to time the market, it is a way to average into higher yields while still maintaining some flexibility and reducing overall portfolio volatility.

3. Use TIPS to hedge inflation risk. Investors might also want to consider Treasury Inflation Protected Securities to help hedge inflation risk. TIPS are designed to keep pace with inflation as measured by the Consumer Price Index (CPI).

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.

Each bond bear market is unique, but we believe with the right strategy, they can  be manageable. 

 

1 A secular market is one that is driven by forces that could be in place for many years.

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