Silencing the roar of the bond bear

Garth Friesen is Principal at III Capital Managment. He has been investing in global markets for 20 years. This article originally appeared on his excellent Tumblr.  You can also follow Garth on Twitter.

The bond market bears are roaring again. The pundits are out in full force, announcing that the fixed income market has finally reversed direction and yields are going to start their inevitable march higher on a path to “normalization.” These predictions are often accompanied by advice to sell your bond portfolio before it melts down in value. Let’s put “melt down” into perspective.

A favorite tactic of the bears to scare you out of fixed income holdings is to quote the performance of the long bond (or an ETF that tracks that part of the curve, like TLT). For instance, they would highlight since the beginning of February, TLT has sold off roughly 14%, which is a huge amount compared to its paltry 3% yield. They would fail to tell you that other segments of the fixed income market such as high yield (HYG) and short-dated investment grade corporate bonds (CSJ) had positive returns during that period. HYG was up 2.1% and CSJ returned 0.4% during that same time period.

Using TLT as a barometer for fixed income is like using a 3x levered ETF on the Russell 2000 index to gauge stock market performance. The interest rate duration of TLT is 17.3 years, compared to 5.1 years for a broader representation of the bond market like the Barclays Aggregate Index (AGG). The duration of TLT is a whopping 3x that of AGG.

A duration of 5.1 years means that the expected impact of an instantaneous 100 bp increase in yield would result in a decline in portfolio value of 5.1%. However the yield on the portfolio would buffer that impact. For example, if the increase in rates took place over one year, and the yield on the portfolio was 2.1%, the net impact would be -3% (5.1% capital loss, with 2.1% added back). Not exactly what people are looking for out of their core bond allocation, but not a disaster either. It is certainly better than the expected loss of 14% that would occur under the same scenario for TLT.

So, just how typical are these types of drawdowns on a broad fixed income index like AGG?

I looked back over the last 25 years and calculated the quarterly returns for AGG (on a calendar basis, not on a rolling basis). The worst 10 quarterly returns are shown in the chart below, along with the returns of the S&P 500 index in those same quarters.

The worst quarter for a core bond portfolio was the 3-month period ending in March, 1994, when the Fed surprised the market with a series of rate hikes. During that period, bonds lost 2.9% and the S&P 500 was down 4.4%. In that quarter, both equities and bonds posted negative returns. It’s important to note equity market weakness during periods of losses in the bond market is not a given. In fact, equities had a positive return in 6 out of the 10 quarters when bonds had their worst returns.

Two things jump out in this analysis. First, 3% as the worst calendar loss in the last 25 years is not that horrific. Second, equity returns during those time periods were significantly more volatile. In other words, for a balanced portfolio, equity markets really drive overall performance.

Given that equities are the main driver, it would be interesting to examine bond market returns when EQUITIES are performing poorly. The chart below shows the 10 worst calendar quarters for equities since 1990, along with core bond market returns during those periods.

The worst quarterly return for equities in the last 25 years was Q4, 2008, when the S&P 500 lost 22.6%. During that quarter, AGG returned 4.6%. It is interesting to note that in every single one of the worst 10 quarterly equity drawdowns, bonds had a positive return. Simply put, history has shown that when equities are performing their worst, bonds are still providing positive returns. This negative correlation to equities is consistent during times of significant equity stress.

So before you get caught up in the hysteria about the recent bond market weakness, try to keep perspective about why you bought the bonds in the first place. If one of those reasons was to gain exposure to an asset class that has historically provided positive returns when equities are doing the opposite, then jettisoning your bond portfolio may not be the smartest idea. Not all segments of the fixed income market will perform poorly. Let the pundits panic.