Forget about the fiscal situation for a moment. Forget ratings, forget Budget Deficits. Here’s the real risk that investors need to worry about. It isn’t default. Its rising rates.
Is it reasonable to assume that interest rates will stay at record lows for long? When one understands the cyclical nature of markets, the answer is no. Investors should expect at least a reversion to the mean.
The chart to the right compares the major bond markets over the past 50+ years. You can see from the chart that all the markets move together.
Yes, there can be short term divergences here and there, but generally, bonds, whether they are Muni’s, Corporates, Treasuries, Mortgage or Junk, all move together. As rates rise, bond prices decline and as rates decline, bond prices rise.
Bonds have enjoyed a longer stay at the bull market party than stocks, having now lasted almost 30 years in a bull market.
But that could be coming to a sudden and dramatic end. Interest rates could spike up the way they did in the late 1970’s, a previous period of high inflation.
Even without a spike up, the chart shows a very obvious cycle. The next major move in interest rates is more likely to be up, simply because there isn’t much downside left.
The tables to the left show what happens to bond prices when rates rise. They decline. And with rates as low as they are, the declines can be significant.
Lets say you bought a 30 year Treasury with a face value of $1,000 this past week with a yield of 3.45%. You paid par, $1,000. Then in one year, rates went back to 4.84%, the average since 2000. Your bond would drop on the secondary market by about 20%. The table shows if rates rose to 4.50% the bond would drop to $831.77 (a decline of 16.82%), if rates rose to 5.00% the bond price drops to $765.31 (a decline of 23.47%)
Did the 3.45% interest you received offset the 20% decline? Not in my book. (Now I’m required to tell you that if you held the bond to maturity, you would get 100% of the face value of the bond. ….Maybe.)
Let say that after three years, the 30 year rate went back to its historical average yield of 7.43%. This is not unreasonable to assume. Your bond price would drop to about $536.62, a drop of about 46% in just 3 years.
It is likely that in order for rates to have risen to 7.43%, they did it gradually over the 3 years. This means as an investor, you watched your bond drop in price slowly over three years. And until interest rates come back down, the price won’t come back, (until maturity.)
But you don’t buy 30 year bonds. Who does? (Insurance companies, banks, pensions, Social Security, foreign countries… And they have to show the marked to the market value on their books, so a decline in price can have devastating impact on the balance sheet of an insurance company or bank.)
So lets say you buy 10 year bonds. You are almost in the same amount of trouble. Lets suppose you bought a $1,000 face value 10 yr Treasury with a yield of 2.07% this past week. Again, you paid par, $1,000. One year later, rates are back up to 4.27%, the average since 2000. Your $1,000 bond would drop to about $840, a drop of about 16% in one year. If in three years rates went back to their historical average of 6.76%, your bond would drop to about $745, a drop of over 25%.
Does the 2.07% yield offset the 25% decline in three years? Of course not. Here’s the scary part – this is not the worst case scenario.
If five years from now, rates went back to their previous highs (15.84% in the early 1980’s), the $1,000 10 year bond price would drop to below $566.00, a drop of 44%.
If five years from now the 30 year rate went back to its previous high of 15.21% (also early 1980’s), the $1,000 30 year bond bought earlier would be worth less than $253.00, a decline of 74.70%. (Yes, if you hold to maturity, you would get the face value back, but I have never seen an investor that would have the patience or would be able to stomach watching their portfolio drop 74% in five years.)
The real issue here is not individual investors holding 30 year Treasuries, it is the banks and insurance companies that have to show the market value on their balance sheets and could become insolvent due to the market value declines. Insurance customers could be at risk as well as bank customers. This gives you an idea of how rising rates could affect more than just those invested in the bonds.
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