Unseen Risks Lurking In The Bond Market

Jan 2020

Over the last thirty years bonds have become a staple for investors looking to reduce risk in their portfolios. Until interest rates normalize, we recommend investors re-examine the role bonds play and consider finding other ways to reduce risk in their portfolios.

Why are we so concerned with bonds when most investors and other investment professionals see bonds as the safe, conservative part of their portfolio? Having a better understanding of the two primary components of risk and how they can adversely affect bonds, should help explain our thinking.
 

Interest Rate Risk

As interest rates move up, the value of a bond will likely go down in value. For example, if interest rates were to rise 2%, the value of the average 10 year investment grade corporate bond would decrease in value approximately 15%1. If you hold the bond to maturity, and the bond does not default, you would get the full value of your investment back in 10 years. However, if you need to access that capital during a time of rising rates, you would have to realize a loss. Even if you don’t need the money, the emotional impact of seeing what investors perceive to be their “safe money” go down a lot, may cause them to realize losses. Our message is that with interest rates at all time lows, there could come a time where rising rates have a significant impact on the value of bond prices.

Are Rates Poised to Increase?

10-Year Treasury Constant Maturity, 1/1/1962-1/1/2020

Source: St. Louis FRED, 10 Year Treasury Constant Maturity Rate, Quarterly, Not Seasonally Adjusted as of 1/1/2020

Higher Rates will Hurt Bond Values

Impact of 2% Rate Increase on Bonds by Maturity
(Investment Grade Bonds)

Default Rate Risk

Most bond investors are aware that if interest rates move up, the value of their bonds will likely go down. However, we are concerned that default rate risk is not commonly understood or appreciated today. Owning an investment grade bond, mutual fund or ETF doesn’t mean you are immune to risk or principal loss.

We need only look at 2008, as an example of what can happen. During this time there was a tremendous amount of rating downgrades due to a painful recession. This put a lot of pressure on the bond market as liquidity dried up, prices dropped and default rates spiked. While the government stepped in to help stabilize the situation there is not guarantee this will happen the next time the bond market experiences a significant decline.

Cumulative Historic Default Rates by Credit Rating


Source: Moody’s Investor Service Corporate Bond Defaults 1970 – 2012 Cumulative Default rates across 20 year maturities normalized
Why are investors particularly vulnerable today? Historically, 25% of the corporate bond market was rated BBB. In recent years, that number has gone up dramatically. In fact, 50% of the corporate bond market is now rated BBB.2 There are two ways to view a BBB rating: as investment grade or one level above junk status. During economic downturns many BBB rated bonds become more fiscally challenged. As a result, they can be downgraded to junk status. When a bond gets downgraded to junk status there are many bond holders that are forced to sell because their mandates don’t allow them to own bonds rated below investment grade. This results in heavy selling pressure on the price of these bonds. In addition, these companies have to pay higher interest rates in order to borrow money now that they are junk status. In 2008, the number of companies that defaulted on their obligations quadrupled over the previous year.3

Should we get out of the water?

We are not making any predictions, however, we are aware of these risks and prepared should the price of bonds start a significant decline. An investment grade bond is only investment grade as long as the rating agencies deem it as such. Once they get downgraded their price can come under pressure, they can lose access to the capital markets, and some times simply cannot pay back the lenders.

With interest rates at all time lows and the percentage of BBB rated bonds at all time highs, there is more risk in the bond market than most investors realize.


1) Source: The American Association of Individual Investors
2) Source; Bloomberg
3) Source: Reuters

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