No One Remembers When Bonds Went Truly Bad

No One Remembers When Bonds Went Truly Bad
Job seekers speak with employers at the Veterans on Wall Street job fair in New York
Photograph by Scott Eells/Bloomberg

All this consternation and kvetching—“headline risk,” traders call it—over a comeuppance in the bond market. Makes you wonder if investors and Wall Street, with its battalions of freshly hatched MBAs, have enough of a frame of reference for when a bond bear last truly happened: in 1994.

Mind you, that was also when this writer was in the throes of high school senioritis, as egged on by his 56k modem. But I’m also told it was an annus horribilis for Wall Street. For three years after the Gulf War recession, the Federal Reserve had kept rates low—“low” in those days was 3 percent—to help the financial system recover from its then-epic savings and loan crisis. When the Fed tightened, Wall Street’s bond-trading operations convulsed like they hadn’t since the 1920s. Treasuries fell a mere 3.3 percent in 1994. But U.S. bond expectations are built into everything but the water supply—which is a recipe for disaster when the Greenspan Fed, sensing inflationary threats, had to almost double its target funds rate to 5.50. All manner of fixed income sold off first, asking questions later.

Of course the world should learn from that bond bear, the likes of which took down hedge funds and brokerages. But has it maybe forgotten, now that every rise in interest rates over the past several years has been a head fake, keeping the bond bull running?

April Rudin is an adviser to wealth managers and other financial-services outfits. Most brokerages, she says, “have no communications plan” for when the bear strikes. “Instead,” she says, “when there is good news they reach out to clients, and when there is bad news they hide under their desks. Some younger investors or others may not be aware when they should be preparing their clients ahead of time, and not just when in crisis mode.”

Bloomberg’s Dave Wilson worked his terminal magic to hook me up with a July 1994 story about a rare breed of activist fixed-income investor known as a “bond vigilante”: he who ratchets up government bond yields to punish politicians and heads of state for their fiscally dangerous spendthriftiness. “Anytime a government or a central bank does something that the markets perceive as potentially inflationary,” remarked then-Dallas Fed President Robert McTeer in the piece, “then you see it immediately in long-term bond prices.” Those macro-marauders helped push up U.S. 10-year Treasury yields to 7.28 percent from 5.79 percent; Germany’s bonds to 7.04 percent from 5.53 percent; and poor old Canada’s to 9.16 percent from 6.63 percent. (Bond prices move inversely to yield; the more rates shoot up, the more yesterday’s and today’s buyers lament committing to their lower-yielding issues).

One Seinfeld, Friends, and Sopranos later, legions of new brokerage “producers” are being recruited from business schools and colleges. None were financially aware in the age of the vigilantes and, before that, the bond-mauling interest rate environment of the late 1970s and early ’80s.

Today, according to the Leuthold Group, if corresponding interest rates were to shoot up a mere point from where they are now over 12 months, a T-bond maturing in February 2031 would sustain a total hit of between 6 percent and 11 percent (your yield gets subsumed by the bond’s plunging price).

So what about the clients of those greenhorn brokers? To what extent are investors soaking in these loss hazards at a time when taxable-bond funds have taken in $310 billion in just two years?

In a thoughtful Morningstar survey, “Why Are Investors Buying Bonds?” small investors betray a good deal of naiveté. “Many,” wrote Morningstar’s Christine Benz, “noted that hurtling toward retirement—combined with the memory of clawing their way back from losses during recent bear markets—had prompted a greater bond allocation in their portfolios.”

“We can’t afford to take a 2008-like hit at this point,” responded one small investor.

“The yields aren’t amazing—anywhere from 2% to 6% depending on the maturity date—but I sleep at night,” said another.

“I don’t care at all about forecasts that future bond returns will be low; bond returns are normally low, compared to stocks,” said another. “I own them to preserve capital in downturns, not for their returns. I don’t especially care that their interest rates are low, although this does influence my choice of bond types. I have never fallen for the fallacy that interest has any relationship to income.”

The stock market’s many crashes since the dot-bomb have transpired in an age of information overflow. “Twitter, blogs, and the like,” says Rudin, “have shown they can move markets. That is a seismic difference between 1994 and now: the speed and amount of information.” Yet somehow that echo chamber has yet to process a potential crash in bonds.

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