Managing Obvious Risks
By Roger Nusbaum, AdvisorShares ETF Strategist
Over the last few days I’ve found a couple of great quotes/snippets that I think are very helpful in understanding the risk that exists in the bond market. I’ve been very wrong about when interest rates would have started to normalize and hell, maybe they never will but if you think rates will at some point move at least closer to what the historical norm has been then it is important to understand the risk and understand what could happen to asset prices when/if this happens. I’ve been writing about this for a long time so hopefully it is helpful to see these concerns expressed by others as well as to see some supporting numbers.
First Jesse Felder Tweeted out a quote from Ray Dalio at Bridgewater;
It would only take a 100 basis point rise in Treasury yields to trigger the worst price decline in bonds since the 1981 crash.
That may not by quite right as treasury yields moved more than 100 basis points in 2013 (more on that below) and there were some large declines but it was nothing like 1981. The quote does convey Dalio’s concern however for where the bond market is and where Dalio is well known for a risk parity strategy it will be interesting to see how his All Weather portfolio changes if/when rates start to go up in a meaningful way.
The period of 1979-1981 was before my time in markets but the price declines as rates went up were staggering in any context let alone a fixed income context. It would be worth tracking someone down who was in markets at that time to get a firsthand account; carnage.
In terms of some context, closed end bond funds are course very popular for retail accounts. They generate very high payouts thanks to the use of leverage and the willingness to return capital to maintain the payouts (hopefully no one is using CEFs without knowing about these factors).
Regarding closed end funds Barron this week reported;
Leveraged national closed-end muni funds lost an average 13% in price during the so-called taper tantrum in 2013 when Treasury yields spiked to 3% from 1.6%.
Yields of course made their way back to 1.6% so it is possible that any 13% declines have been made back but there is no guarantee of that and even if a given fund recovered from the last bond market event there is no guarantee that the same fund can recover from the next event. There are two reasons for this. The common reason given, and it is true, a bond fund has no par value to return to. Assuming no default, an individual bond will revert back to par at maturity. A bond fund has no par value or maturity date (there are a couple of exceptions on funds with “maturity” dates).
The other point here is that if/when rates normalize off of the financial crisis it might take 50 years (or until the next crisis) to get this low again. Financial crises/bank panics/depressions used to happen much more frequently than they do now. While it seems like they happened every five or ten years in the 19th century, the frequency slowed down and the one in 2008 was the first one since the 1930’s. Too much in relatively volatile fixed income funds could result in a truly permanent impairment of capital.
The last quote is from a Todd Harrison Tweet;
Smart guy to me, once: “Just manage your risk the reward will take care of itself.”
This message is harder to absorb in the middle (or end) of a bull market but managing the downside is more important than managing the upside. After a 35-year bull market for bonds, it will become more important to manage the downside in the fixed income portfolio than to squeeze out the maximum yield possible from the entire portfolio.
Most investors won’t be able to afford to have their entire fixed income portfolio in two-year investment grade paper yielding 80 basis points but they probably need some as that is one segment that helps to manage the downside.
In past posts I’ve mentioned things like floating rate and shorter dated high yield (there are others too) as ways to capture yield but used in modest allocations as things can go wrong there. Things can go wrong in any segment but the idea of rising rates is an obvious risk to manage.