Has the Bear Market for Bonds Begun? (Schwab)

April 5, 2012

by Rob Williams, Director of Income Planning, Schwab Center for Financial Research, and

Has the Bear Market for Bonds Begun?

Why are interest rates still so low? The economy is recovering, unemployment is falling, gasoline prices are rising and the stock market has doubled in value in the last three years. We’ve noted the commentary lately about an end to a 30-year bull market in bonds, and whether investors are at significant risk for losses if rates rise. The tendency, as we’ve seen it, is to worry about these broad concerns with a mix of skepticism and fear. While we think that interest rates will continue a modest increase over the rest of this year, we’re less convinced that we’ll see a sharp, uncontrolled spike in rates or decline in investor demand. We see other long-term structural supports, with a few of the larger ones highlighted here.

• De-risking supports demand for bonds. The simplest explanation for why rates are so low is that investors—individual and institutions—are still ‘de-risking.' For individual investors, the explanation for the propensity to favor bonds over stocks is pretty straightforward. Since 2000, individual investors, in aggregate, have gone from prince to pauper one too many times. After a period of low volatility during the 1990s, we’ve moved to a period of exceptionally high volatility. Not only have returns from the stock market been volatile, but net worth has been volatile as well thanks to the drop in home prices. Aging investors may simply want to hold on to more of what they have, supporting demand for bonds.
• More importantly, institutional investors are de-risking as well. We focus on individual investors, of course, but the U.S. bond market has been driven, by-and-large, by large institutions such as pension funds, insurance companies, global banks and international sovereigns. This is an enormous market, and they are de-risking as well. In our view, pension funds, insurance companies and others with liabilities to fund have been, and will likely continue, to reduce exposure to riskier assets in favor of bonds. Here are a few statistics:

1. According to Ned Davis and the Federal Reserve, in 1953 bonds accounted for 84% of assets invested in U.S. insurance and pension funds. The percentage has fallen steadily since then, to 40% of $15.7 trillion in global assets as of the end of 2011. (Yes, trillion.) Over the same period, the allocation to stocks rose from under 8% in 1953 to peaks of over 42% in the late 1990s and mid-2000s before falling back to under 34% today with the rest allocated to bonds and other investments.
2. According to Milliman, a pension fund consulting company, corporate pension funds are under-funded by $372 billion. Municipal pensions are under-funded by trillions more. After disappointing returns from equities, many are shifting slowly back to a more traditional method of matching fixed assets with future liabilities. On the margins of this multi-trillion dollar market, a one-percentage point move is a big deal.
3. Insurance companies face similar metrics. Many will need to add more fixed income to match future liabilities. According to Mercer, an insurance consultant, demand for fixed income securities from insurance companies could run in the range for $500 to $600 billion annually.

• Demographics are also changing. It's no secret that the U.S. population is aging and that the first wave of "baby boomers" is retiring. Some have been pushed into early retirement while others have chosen to stop working. It’s our sense that many investors may remain less inclined toward extra risk with the money they have to live on for the next few decades, for a growing portion of their portfolios. Return of capital, in nominal terms, may be as important as return on it, at least for money that doesn't have as much time to recover from volatility in other markets.
• And then there's the Fed. The other big factor holding down yields, of course, is the Fed. Over the past year, the Fed has purchased 61% of new Treasury issuance, keeping a cap on rates. With the fed funds rate at zero and the Fed buying long-term bonds, yields are likely to remain low as long as those policies are in place. Right now, the Fed is indicating that the policy is expected to last another year or more. We’ll know more when they meet next in late April to see if they communicate any change in tone. But for now, statements from Fed Chairman Bernanke and others show that the Fed remains cautious about the strength of recent economic numbers, still worried about slowing growth in Europe and China, and believes that unemployment needs to be lower before they are close to fulfilling their mandate.
• This analysis is not meant to say that interest rates will stay low forever or that long-term Treasury bonds are attractively valued. At some point, when the economy appears to be on firmer footing and/or inflation expectations rise substantially, the Fed is expected to begin to unwind its programs and interest rates are likely to move higher. We've already seen a modest rise in rates off lows in late March, and we'd expect to see a slowly rising trend through the rest of the year. We look forward to the time when rates begin to move up a bit, actually, because it’ll mean that the economy is healthier and investors face additional options for return on their savings. However, we don't know when that time will arrive, and we're not in the camp that sees rates rising dramatically anytime soon for many of the reasons we've cited above. Still, we think it’s a good time to look at your allocation to different types of bonds, by credit risk and maturity. It's difficult to predict interest rates, and you can’t control them. But you can control what you hold in your portfolio.

Q1 2012 Sector Performance

The wide range of performance between different sectors of the global bond market, by maturity and level of credit risk, reminds us that the bond market defies easy generalization. Not all bonds are created equal. During the quarter, there was a sharp price-driven appreciation in ‘riskier' assets, such as corporate, high yield and emerging market bonds, while long-term Treasury bonds fell as yields rose. Overall, we expect we'll see similar performance by sectors through much of the rest of 2012, with yields rising modestly for Treasuries on improved economic data, with periods of volatility and re-trenching if we see weaker data or concerns about global growth.

• Flat line on returns for the taxable bond index. The Barclays US Aggregate Bond Index turned in a meager performance over the first quarter, delivering 0.3% in total return on the combination of coupons and a modest drop the price of the index as yields for government bonds rose sharply in March. For those focused on income, the index is now yielding north of 2.2% with an average duration (i.e. the weighted average timing of interest and principal payments, and a measure of interest rate risk) of just under 5 years. We expect that income will drive returns for much of the rest of this year, with a range on interest rate risk most likely through year-end.
• Investment grade corporate bonds, including financials, outperformed. High-grade corporate bonds were the primary beneficiary of increased risk-appetites and yield-chasing, a theme that's continued from late 2011 into 2012. But performance was not spread out evenly across asset classes. The financial and banking sector, a laggard as recently as Q3 2011, beat utilities and industrials over the last three months. This is thanks in part to improving market conditions and no real negative surprises in the Fed's recent bank stress tests. Few investment-grade sectors look cheap now, a concern for investors who have been looking for yield and pouring money into corporate bonds. We're more cautious at the moment, given the strong recent run. It may make sense to look for opportunities when they present themselves at more attractive levels. The cycle, to us, still favors credit.

Q1 2012 Sector Performance

Source: Barclays, as of March 30, 2012. Shown above are total returns for corresponding Barclays indices. Past performance is not indicative of future results.

• High-yield returns show the shift in sentiment toward yield and risk. More return potential means more risk, of course. We think the cycle still favors credit, as we've said, with high yield beating the pack with a 5.3% return for the quarter plus a 5+% yield premium over Treasuries. With corporate balance sheets generally appearing strong, it looks like investors are being adequately compensated for risk, relative to the alternatives. An important consideration, as always, is not to push the investment thesis too far, tilting too far away from the more conservatively invested core bond portfolio in the search for yield.
• Euro-zone risk eases, boosting international performance. Eurozone troubles are far from over, but two rounds of liquidity injections and orderly Greek ‘restructuring' did help to temper uncertainty so far in Q1. Foreign bonds benefited, while emerging markets benefited more, due primarily to the improved appetite for risk assets. Emerging market debt mirrored U.S. high yield for a 5.9% total return. In the current low-rate climate, a combination of emerging market and U.S. high yield bonds may still make sense for the more ‘aggressive' sleeve of a more risk-seeking portfolio.

Measuring Interest Rate Risk

We started the conversation in this newsletter with thoughts on the bull market for bonds. Is it over? More importantly, is the bear market for bonds underway? If rates rise, what risks do you face? Measuring risk is better than guessing, in our view. Duration—the weighted average time until payment of interest and principal on bonds—is one measure.

• The U.S. taxable bond market has a duration today of 5 years. The average maturity is around 7 years. The tendency is to look at and refer to the 10-year or 30-year Treasury as a benchmark or bell-weather for the larger market for bonds. But it's worth remembering that the market as a whole has shorter maturities on average. Longer-term bonds are riskier, if rates rise. But long-term bonds are part, not all, of the entire market. If you hold a portfolio with a mix of short- to intermediate-term bonds, you may not have much exposure to long-term bonds. A portfolio focused on short- to intermediate-term bonds, with maturities between 1 and ten years, is good place to start, in our view, for most investors.
• A taxable bond market with duration of 5 would be expected to fall roughly 5% in value if rates rise 1%. This estimate is a rule of thumb, using duration as a measure of risk. It assumes a 1% increase in rates across the yield ‘curve'—meaning at every maturity, and for every bond. If rates across the curve rise 2%, from 2.2% to 4.2% on the 10-year Treasury, for example, and at every other maturity from one out to 30 years or more, the value should fall 10%. This is rough, but gives a sense of how much damage an investor might feel if invested in a broadly diversified portfolio of short- and intermediate-term bonds or funds. Shorter-maturities are less sensitive, generally, if rates rise, than longer-maturity bonds. Bonds with higher coupons are generally less sensitive also, compared to bonds (Treasuries, for example) where coupons tend to be lower. The income paid by bonds in the form of coupons offset a portion of these price changes, especially if interest is reinvested at higher yields and compounded over time.
• The current benchmark duration of 5 is also around the average duration for the average intermediate-term bond fund. Intermediate-term bond funds have durations of 3.5 to 6 years (or, if duration is unavailable, average effective maturities of four to ten years), using the definition that Morningstar uses to define mutual fund categories. “These portfolios are less sensitive to interest rates, and therefore less volatile, than portfolios with longer durations,” says Morningstar.
• Short-term bond funds have a duration of one to 3.5 years, on average, according to Morningstar. So if short-term rates rose 1%, short-term funds would be expected to fall in value by 1% to 3.5%. We generally suggest short-term bonds or funds for money needed within 1 to 3 years, with cash investments or bonds that are nearing maturity for money needed sooner. Short-term rates will rise, ultimately. But it seems less likely that they will until the Fed changes policies and says that they will, to us. The Fed can generally drive short-term rates more directly than they can long-term rates using traditional monetary policy including the Fed funds rate.
• In contrast, long-term bond funds, especially those with heavy Treasury exposure, involve the highest risk if rates rise. Durations for long-term funds are generally 6 years or longer, often considerably longer. This is where investors who have benefited from strong capital appreciation in long-term bonds or funds can look to take some ‘duration' off the table, re-positioning a portion of strong gains by shortening duration back to benchmark. It may not be the most attractive place, in our view, for most investors to think about adding money now.
• You can target duration, using ladders or funds. As a place to start, we think investors should consider a mix of short- and intermediate-term bond funds, for a mix of lower interest rate sensitivity (in short-term funds) and income potential with moderate risk (intermediate-term funds). It may sound like a broken record, we know, but we still like bond ladders with a mix of maturities from ready-to-mature out to around 10 years. When interest rates rise, there will be short-term bonds maturing to reinvest for higher yields. And ladders can help reduce the overall volatility in the bond portfolio. This kind of portfolio helps with a plan to manage interest rate risk proactively.

Please visit www.schwab.com/onbonds for more fixed income perspective from the Schwab Center for Financial Research. If you have questions or concerns about the issues raised in this publication, please speak to your Schwab representative.

Important Disclosures