1994 was a monumentally disastrous year for bonds. Dubbed the “Bond Market Massacre,” a Federal Reserve hike sent bond yields skyrocketing, crushing fixed-income investors.
According to a new white paper from Clearbrook Global Advisors, a New York City-based investment-advising firm with more than $30 billion in assets under advisement, the current market is set up for an eerily similar disaster.
Here’s a recap of the situation in 1994 from the paper:
In January 1994, the economy was in its 34th month of expansion, bond yields were historically low and inflation was muted as well. Wage growth was essentially flat, and corporations had little pricing power. The Federal Reserve believing it would stem a quick potential rise in inflation, began to raise interest rates.
What happened next was a calamity. Short-term bond interest rates jumped up to 2.25% by the end of the year. Yields on 10-year Treasuries increased from 5.92% to 7.84% during that year. That caused the “Massacre.”
“In base bond maths terms the rise in the 10-year Treasury yield of 1.92% multiplied by a duration of 10 years equates to a 19.2% loss,” said the paper. “In short, 1994 became the year of the worst bond market loss in history.”
Clearbrook, which serves as advisor to large institutional investors with a focus on nonprofits, said that estimates made at the time suggested around a $600 billion loss for fixed-income investors during 1994.
It could be even worse
The bigger worry isn’t only that current conditions mirror 1994, says Clearbrook, it’s that investors are three times more invested in bonds than they were 21 years ago. According to the paper, the total amount of bonds outstanding in 1994 was $10.8 trillion. Today that number is $39.2 trillion.
“Imagine the magnitude of a market correction should an interest rate spike happen today due to a potential misstep by the Fed or another central bank,” said the paper.
In addition, the world has greatly changed since 1994 with the explosion of financial derivatives and their inherent leverage, growth of illiquid fixed income securities, complex computer and electronic bond trading systems, and the ever growing correlation between global and regional moves in economic trends and interest rates.
Clearbrook said that the point isn’t to scare, it’s merely to point out the dangers of the situation. It said:
We do need to be wary of the real potential of a bond bubble, and identify the preventive measures investors can take to help mitigate large losses in a potential market event.
The possible hard landing due to illiquidity in the bond market makes the smart move to cover oneself.