Markets

Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets. She has written about debt markets for Bloomberg News since 2010.

Ray Dalio thinks bond markets are on the brink of a significant shake-up.

Dalio, the billionaire investor who created Bridgewater Associates, wrote in a Linkedin.com post on Tuesday that "there's a significant likelihood that we have made the 30-year top in bond prices." When these extreme moves happen, some investors will be shaken out of their positions, "making the move self-reinforcing" for a while, he wrote.

Dalio seems to be predicting a prolonged and potentially messy bond-market selloff. He isn't the first big investor to call a top for debt markets that have been inflated by central bank policies. But his comments have particular resonance. Many traders are starting to price in higher inflation rates, and bondholders have just experienced the worst selloff in years. 

Inflation Ignition
Inflation expectations over the next decade climbed after Trump's election as the next U.S. president
Source: Bloomberg

Not all market downturns are the same, and how they unfold determines who stands to gain and who stands to suffer. So what might this one look like, and which slices are most at risk?

Let's say inflation expectations pick up significantly. This is already happening to some degree in the wake of Donald Trump's election as the next U.S. president because he's promised a robust infrastructure-spending program. But Trump needs to come through with some realistic details to bolster inflation expectations further and to prompt the Federal Reserve to raise interest rates faster than many are now expecting.

Shaken Awake
Benchmark U.S. bonds sold off, sending yields markedly higher afterTrump's election as U.S. president
Source: Bloomberg

Assume Trump moves quickly on crafting fiscal stimulus that requires the U.S. to borrow a lot more money. While many unknown factors would still be at play, Treasury yields would most likely keep rising, spurring deep losses for owners of U.S. government bonds. Already this month, Treasuries maturing in more than 15 years have plunged 6.6 percent, set for the biggest monthly loss since 2013.

Pain Spectrum
Long-dated U.S. government debt has been the biggest loser so far this month
Source: Bank of America Merrill Lynch index data

The more these benchmark yields climb, the more corporate debt comes under threat. That's because of two factors: one, as benchmark borrowing costs rise, some investors, from pension funds to foreigners, will start to see more value in debt backed by the U.S. government than bonds of companies that have relied for years on historically low borrowing costs. And two, higher rates typically slow growth, especially if paired with higher consumer prices that aren't accompanied by commensurate gains in wages.

So which part of the debt market would suffer most? In the short term, it looks as if U.S. government bonds are in a bad spot. But these notes will eventually find natural buyers if their yields rise high enough. Plenty of pension funds are looking to earn enough regular income to meet their obligations and would be more than happy to do so in a less-risky manner than delving into private equity and hedge funds.

Relative Yields
U.S. benchmark yields are now the highest on record relative to comparable German rates
Source: Bloomberg

Corporate debt is another story, especially notes of lower-rated companies that can't really afford to repay their debt at their current pace of growth. Right now, investors are finding a relative haven in company bonds. Junk bonds have lost only 1.3 percent in November compared with 2.2 percent for investment-grade bonds and Treasuries.

But that could easily change should this selloff continue to unfold. While much remains to be determined, company bonds may shape up to be the most vulnerable.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Lisa Abramowicz in New York at labramowicz@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net