With the 10-year Treasury yield bouncing around 3%, rates have more than doubled from the all-time lows reached in 2016. This increase in yield has triggered a corresponding decline in price for both government bonds and fixed income in general, with the Barclays Aggregate Index (a broad-based fixed income index including U.S. treasuries, corporate and other bonds) down over 1% year to date.
Interest rates and bond prices have an inverse relationship. When yields increase, it causes the price of existing bonds to decline, as investors require a discount to purchase bonds having a lower coupon than newly issued bonds. Conversely, when yields decline, it causes the price of existing bonds to increase as they become more attractive relative to newer issues with lower yields.
The recent increase in yields off their all-time lows has caused market commentators to declare an end to the multi-decade bull market that began in the 1980s, and the start of a new “bear market” in bonds. A bear market in stocks is colloquially defined as a price drop of more than 20%, but a bear market in bonds is much more loosely defined. It is important for investors to understand the historical context of the current bond bull market and what to expect out of a bond bear market.
The recent bond bull market began in the ’80s when yields peaked just north of 15%, with the persistent decline in interest rates after acting as a tailwind to fixed income investors.
The record high interest rates in the ’80s corresponded to a period of prolonged inflation, with CPI inflation just under 15%. These high levels of inflation forced fixed income investors to demand higher yields to compensate them for their eroding purchasing power. The bond bull market that followed was the result of this high inflation moderating and was reinforced by the sustained low inflation environment afterward. This allowed bond investors to achieve total returns greater than the yield alone would imply as bond prices generally rose over the period.
Over the last decade, U.S. interest rates have hit all-time lows, with the Federal Reserve lowering short-term rates to help spur the economy in the aftermath of the 2009 recession. These low rates were kept in place for the better part of a decade due to a slow economic recovery and stubbornly low inflation.
These conditions have started to ease in recent years, with inflation picking up modestly and continued economic growth leading the Federal Reserve to start raising rates in 2015. After bottoming in 2016, the 10-year yield has steadily increased over the last few years, hitting 3% this year for the first time in almost five years.
This increase in yield has given fixed income a negative total return over the last two years. Between July and December 2016, the Barclays Aggregate Index experienced a decline of 4.4%, recovering those losses only in August 2017. After making new highs in September 2017, fixed income once again reversed course, losing 3.3% and entering a new “bear market” from which it has yet to emerge.
What to Expect when You’re Expecting a Bond Bear Market
At just under one year, our current bond bear market is the 7th-longest bear market of the last 40 years, with 15 other periods experiencing a larger decline. Over the last 40 years, the longest it took for Barclays Aggregate Index to recapture its previous peak was 16 months, with the largest drawdown a decline of 12.7%. In this context, our current “bear market” is rather minor in terms of drawdown (at 3.3%) but it’s meaningful in terms of length.
Compared to equity bear markets, bond “bears” are rather mild; even in extreme scenarios, bonds have done a good job preserving capital. Bond bear markets are also relatively short lived, with investors often returning to breakeven within a year. It is tough to even come up with a meaningful definition of a bear market for bonds, with bonds declining 5% or more only three times in the last 40 years. The last time this occurred was more than 20 years ago.
What is more important for investors to focus on is how their overall portfolio responds to adverse conditions such as these. The S&P 500 was positive in eight of the 10 periods listed above, with an average return of 11.7%, helping a diversified investor weather the storm. Despite dragging down recent returns, bonds remain important, adding income and stability to a portfolio. Even with continued headwinds, investors should stick to their knitting and maintain an appropriate asset allocation.