Regulator Warns Of A Risk That Could Destroy Your Portfolio

Ben Bernanke

The overwhelming consensus on Wall Street today is that the bond market is overvalued and that bond investors will get destroyed when rates inevitability rise.  Last week a major regulator got into the act.  FINRA, the brokerage industry’s self regulatory organisation, put out an “Investor Alert” warning of the duration risk associated with owning long duration bonds in a rising interest rate environment.

In a nutshell, duration risk refers to the concept that the value of a longer duration bond is more sensitive to interest rate changes than that of a shorter duration bond.  (For a more detailed explanation of duration risk see the FINRA Investor Alert.)

It’s not every day that a major regulator makes cautionary comments about market valuation. We applaud FINRA for throwing a flag on the investment field.  The risks for large investment losses are very real (perhaps this is FINRA’s crack at “irrational exuberance”).

Bond prices have been, and continue to be, artificially inflated by Federal Reserve policies.  But the narrative doesn’t end there.  The very same policies that are inflating the value of bonds are also inflating the value of most other financial assets.  What’s concerning is that the anti-bond argument is almost always dovetailed with a pitch to get investors to increase their asset allocation of equities.

The idea that the damage from rising interest rates will be confined only to long duration bonds is naive.  As sure as the sun rises, increasing interest rates will have a negative impact on all financial assets (as well as corporate earnings).  When the Fed takes away the punch bowl, the party always comes to an end.

Higher Rates & Equities – Bad Bedfellows

The Federal Reserve held the Fed Funds rate at 1% from mid 2003 through mid 2004.  During that time, investors were bombarded with the exact same tune we’re hearing today – that bond investors were going to get destroyed when interest rates rose.  And just like today, equities were being heavily touted as the place to be.

By mid 2006, the Federal Reserve had raised the Fed Funds rate by 425 basis points, leaving it at 5¼%.  But something very interesting happened to the bond market… not much.  The yield on the 10-year treasury bounced around in a 75 basis point range.  But equities didn’t fare so well.  When higher short-term rates finally caught up to the equity markets (about a year later), the S&P 500 began its epic 58% plunge.

Likewise, the S&P 500 kicked off its 48% tumble from its spring of 2000 peak after the Fed’s 1999 tightening campaign.  However, contrary to the bond market doom and gloomers, bond investors sat back and tallied the profits while equity investors licked their wounds.

We recognise that the equity bulls will stomp their feet and insist that there will be ample warning signals and plenty of time to get out of the market after rates start going up.  But we all know that isn’t how it works in the real world.  The initial downward move of major market declines is always viewed as a “buying opportunity,” but by the time reality sets in most investors become too paralysed to react.

Will it Be Different This Time?

The fact that the bond market held up as well as it did in the past two tightening cycles won’t likely be repeated this time for three simple reasons.  First, through quantitative easing, the Fed is controlling many aspects of the yield curve, not just short-term rates.  Second, interest rates are so low on an absolute basis that there’s not much of a coupon to cushion against negative price returns.  And third, we don’t have the shadow banking system that we had pre-financial crisis to help offset rising rates.

We think investors should heed FINRA’s warning about the effect that rising interest rates will have on long duration financial assets.  But investors shouldn’t get lulled into the idea that the equity market is a safe haven, and should resist the temptation to raise their equity allocations at this point.  The equity markets are along for the same Fed ride as the bond market, and in many respects equities might be the longest duration assets of them all.

FINRA, Why Now?

As much as we applaud FINRA for getting the message out about duration risk, we are scratching our heads.  The FINRA alert states “Currently, interest rates are hovering near historic lows.”  We have news for FINRA, rates have been hovering near historic lows for several years, so why the warning now?  Perhaps FINRA and the SEC should have required investment advisors, financial planners, and brokers to clearly articulate the risks associated with these long duration investment products before they sold them.

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