Bond Bears: You're Worrying About The Wrong Thing

I see the headlines every day and I’m sure you do too:

The Bear Market in Bonds Is Just Getting Started – Scott Dorf, Bloomberg

Bond Bear Markets Exist (And May Be Right Around The Corner), Ivan Illan, Forbes 

Bonds, Like Men, Are In A Bear Market, Bill Gross, Janus Henderson

Jim Grant: The Great Bond Bear Market Is Already Here!, Macrovoices interview

Five Steps to Protect Against A Bond Bear Market, Steven Goldberg, Kiplinger

All of those headlines are from early 2018 except the last one. That Kiplinger article is from February 2013 and serves to show just how long this fear of bonds has been around. I have been hearing about the “bond bubble” for years now and a quick Google search finds bond bubble articles dating all the way back to 2009. That article, by Ambrose Evans-Pritchard, includes a quote from Mohamed El-Erian, “Get out of Treasuries. They are very, very expensive.” The yield on the 10 year Treasury was around 2.4% at the time versus 2.95% today. Phew, thank goodness you sold bonds nearly a decade ago. 

Another proponent of the bond bubble is Alan Greenspan who at least waited until this year to voice his concerns. There’s a lot of irony in Greenspan, blower of two of the biggest bubbles in history, now declaring that, yes you can identify a bubble before it bursts. Assuming he actually knows what the hell is he is talking about, a considerable assumption in my opinion. Frankly, the fact that Greenspan is worried about a bond bubble is nearly reason enough, all by itself, to buy bonds in bulk with the longest duration I can find.

I spend a portion of every day speaking to investors of all kinds. If there is one thing they all agree on, it is that interest rates have to go up and that is very bad for bonds. And they have agreed on that for years, dating back to the first incarnation of the QEs which were supposedly going to be massively inflationary and devastating for bonds. Except, of course, it wasn’t and they weren’t. One thing I learned very early on in this business is that whatever everyone is worried about can be safely ignored; it’s already in the market. Fears of a bond bear market, of the bursting of a “bond bubble” would certainly seem to qualify.

Of course, things are different now. The Fed is actually raising short term interest rates and is widely expected to keep doing so. That must mean the multi-decade bond bull market is really over this time, right? Surely, with the Fed hiking rates, I should sell my bonds, right?

Well, the Fed is raising short term interest rates because they want to head off any incipient inflation. Forget for a moment that their collective track record is worse than Greenspan’s and that their preferred Phillips Curve model isn’t working now and hasn’t for some time. Isn’t a Fed getting ahead of an inflation surge exactly what a bond owner should want? If inflation is the worst enemy of bond investors – and it is – then how could a Fed seeking to quash it – before it even arrives -  ultimately be bad for bonds?

If you think a tightening Fed is bad for bonds, over anything but a very short time frame, you are implicitly saying one of two things: either raising interest rates won’t work to reduce inflation or the Fed isn’t doing it fast enough. There are probably arguments for both of those but that does not seem to be the case most bears are making. Almost every bearish bond argument I see is based on fears – no, the certainty - that the Fed will keep hiking rates.

Take, for example, the Forbes article cited above. The author cites a tightening cycle of the 1970s to buttress his case that bond bear markets do exist and that this current tightening cycle will usher in a new one:

One such gut-wrenching rate hike cycle occurred from 1977 to 1980, when 10-Year Treasuries went from 6.88% to 11.13% in three short years. With a duration of 9.1 for these bonds, this equated to a market value loss of nearly 40% in three short years. This is an eerie percentage familiarly to the last stock bear market. Most investors don’t keep a fresh memory of the last stock bear market from 2008-09, much less the last bond bear market. But bond bear markets do exist, and they maul just as ferociously as their stock cousins.

Hmm. Really? “Bond bear markets…maul just as ferociously as their stock cousins”? Even if we assume the author is correct when he says the 10 year Treasury price declined by nearly 40% based on the duration (and by the way duration is an approximation; the relationship between yield and price is not linear) that does not mean an investor lost that much holding 10 year Treasuries during that time. What matters for an investor is not the change in the price of the bond but rather total return, including the interest payments. What do we find when we look at total returns for the 10 year note for that period? (Data is from the NYU Stern School found here)

1977  1.29%

1978  -0.78%

1979 0.67%

1980  -2.99%

If we add the return from 1976 of 15.98% or the return from 1981 of 8.2%, the nominal five year return is not exactly fear inducing.

Why is there such a difference between reality and the fear mongering of the Forbes author? Two words tell the story – coupon payments. Yes, I know it is hard to believe but bonds pay interest and those interest payments are quite important. The change in price isn’t irrelevant but it isn’t nearly as important as the bond bears seem to think.

Well, okay, the bond bears will say, but that isn’t what we’re talking about. We’re talking about nothing less than the end of the long bull market in bonds that started back in the early 80s. Okay, let’s take a look at that bull market. From September of 1981 to present the 10 year yield fell from nearly 16% to the current 2.94%. That equates to a price change of about 60% if you maintained a constant 10 year maturity. That’s a pretty big number but it did happen over 37 years. Interest payments over that time? 25 times as large as the price change. No, that is not a misprint.

Are we on the verge of a bond bear market? Heck, the 10 year yield has already doubled off the lows of mid-2016, maybe the bond bear market already happened. Percentage-wise that is a bigger move in yields than any tightening cycle in my 27 year career. So, maybe it happened already and no one noticed?

If we are on the verge of a bond bear market or maybe in one now, it will be the most anticipated bear market in the history of markets. Nearly every investor I’ve spoken to since 2008 has expressed concern about interest rates and bonds. Speculators are holding record short positions in bonds and all the bond bulls could hold a meeting in a closet. And it wouldn’t even have to be a walk-in. And while I do hear a few more stock market bears these days, investors continue to worry more about their bonds than the other parts of their portfolio.

When investors hear “bear market” they naturally think of the kinds of losses we see in stocks during those ursine phases. But history is pretty clear that bond bear markets are an entirely different animal, more of a koala than a grizzly. If you are worried about the bond portion of your portfolio because interest rates might go up, you are worried about the wrong thing.