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Unprecedented selloff in the bond markets and their implications for investors for the foreseeable future.

Bond markets

18 Oct Unprecedented selloff in the bond markets and their implications for investors for the foreseeable future.

Posted at 07:52h in Blog by
Disclaimer: This piece is intended for educational purposes only and not to be construed as investment advice. Please consult a qualified financial advisor before implementing any thoughts discussed in this blog. Opinions expressed in this blog are solely mine and mine alone.
What happened in the bond markets recently?
  • US treasury bond markets underwent a violent selloff since the spring, and yields jumped across the curve. For instance, the yields on the two-, five-, and ten-year treasuries rose 1.4%, 1.65%, and 1.63% during the interim.
  • As the yields rise, bond prices fall to reflect market sentiment. The lower the coupon and the longer the maturity, the bond price changes are magnified due to their effective duration (convexity).
  • This yield spike is primarily driven by resilience in consumer spending (as evidenced by robust retail sales), by the relentless issuance of treasuries to finance the deficit spending by the Biden Administration since the beginning of the fiscal year 2022 - 2023, and by the adoption of a hawkish tone by the US Federal Reserve in its inflation fight by stating that its restrictive monetary policy and the interest rate hikes will remain in place well into 2024.
  • Spooked by the unprecedented deficit spending by the Biden Administration and its issuance of related debt, central banks such as Brazil, China, Japan, and Saudi Arabia halted their US treasury purchases.
  • The vacuum created by the absence of these central banks is now filled by traditional market forces (such as traders from banks, hedge funds, pension plans, and insurance companies) demanding higher yields on longer maturities (term premiums) and driving the bond prices down.
  • For instance, recent treasury auctions of securities received poor interest from investors, thus forcing the primary dealers to absorb large amounts of the debt issuance and incur losses as yields on these securities rose.
  • Also, the US Federal Reserve is currently redeeming approximately $1.0 trillion in US treasuries and agency debt yearly to downsize its balance sheet from the bloated levels of COVID-19. This measure has removed vital support to the treasury prices in the bond markets.
  • Thus, inflation-adjusted (real) interest rates rose across the yield curve, as evidenced by the jump in US Treasury Inflation-Protected Securities (TIPs) yields. For instance, the yields on ten- and five-year TIPs rose to 2.26% and 2.38% in October 2023 from negative 1.1% and 1.8% since November 2021.
  • The bond yields are now at their highest levels since 2007, when the global financial crisis resulted in the Great Recession of 2008 – 2009.
  • The implied volatility in bond prices has far exceeded the volatility in stock prices and is at its highest since 2005.
  • Yield curves, which often portend the future US economic growth, steadily moved from an “inverted” to a “flatter” position, as evidenced by the narrowing of the spread between the two and ten-year treasuries. For instance, the spread fell from one hundred to twenty-eight basis points since July, indicating that the US economy will likely remain robust during the next twelve months.
How did the bond selloff impact investors?
  • The bond markets suffered their worst selloff during the past three years, more than any other time in US history since authentic records became available (Source: Bank of America Research). This selloff is now compared to the dot.com stock market bust towards the end of 1999. For instance, the ten and thirty-year treasury prices have fallen 46% and 53% since March 2020 as yields rose.
  • These elevated bond yields are now aggressively competing with the earning yields on stocks. For instance, the earnings yield on the S&P 500 stock index is now estimated at 5.5% (source: FactSet), compared to 4.9% on default-free ten-year US treasuries. This comparison puts pressure on the equity prices, as evidenced by recent volatility in the US stock markets.
  • Higher bond yields led to a steep fall in the leveraged buyouts in private equity firms, a lifeblood of mergers and acquisitions, to their worst year in a decade in 2023 (Source: Bloomberg Research).
  • Rising rates have heavily impacted the commercial real estate market, which depends on vast sums of borrowing. This has resulted in a spike in the loan-to-value ratios, risking a potential breach of debt terms.
  • Changing structural shifts of working from home and e-commerce made large swaths of office and shopping malls (particularly downtown) obsolete, adding pressures on real estate prices that require borrowers to sell into an already depressed market.
  • Most commercial real estate lending is now concentrated in regional banks in the United States, which could be the genesis for a broader banking turmoil (Source: Bloomberg).
  • The Fed has orchestrated years of bond market stability (2008 – 2020) through its open market transactions, and the yields hovered around 2.0% - which became known as the “new normal.”
  • Now, change is coming to the bond markets, disrupting this equilibrium at such a rapid pace that few could have imagined at the beginning of this year.
What is the road ahead for investors?
  • Expectations of a recession in the United States, driven by the Fed’s tight monetary policy,” never materialized (as of October 2023).
  • The Biden Administration’s trillions of dollars in deficit spending, tight labor markets, real wage growth, and healthy consumer balance sheets in the US counterbalanced the tighter monetary policy, and the US economy is chugging along better than anticipated.
  • US GDP is forecast to grow 4.0% in the third quarter of 2023 (Source: Goldman Sachs) compared to 2.1% in the second quarter (Source: US Bureau of Economic Analysis). The Fed forecasts that US GDP is likely to grow 1.5% in 2024 compared to a forecast of 2.1% in 2023.
  • Thus, US corporate earnings will likely remain robust next year, with a projected growth of 12%. As measured by the S&P 500, US equity valuations currently trade at a price/earnings multiple of 18.1 compared to 18.7 five-year average.
  • While the US could still experience an economic slowdown in 2024 as pent-up demand for leisure and travel and consumer spending has run its course, it is not significant to cause a recession.
  • The Fed officials vigilantly monitor the inflation data for signs of progress but are not ready to declare victory until clear economic indications emerge. Thus, they warn that interest rates will likely remain “higher for longer” in 2024, and any policy decisions are primarily data-dependent.
Reality check in the bond markets:
  • Central banks in developing countries have pursued liberal monetary policies since 2009 to shield their economies from the harmful effects of the Great Recession (2008 – 2009).
  • They have cut the benchmark overnight rates to zero for most of the period between 2009 and 2020 and have further goosed their economies via Quantitative Easing programs (requiring the purchase of long bonds in the open markets) that provided unprecedented liquidity to the economies.
  • These programs have resulted in legions of winners and losers in each economy, with borrowers gaining ground against savers via ultra-low interest rates on loans for the former and zero interest rates on savings for the latter.
  • The ultra-low interest rates regime has encouraged leveraged investments since 2009 in commercial real estate, private equity, and venture capital deals that would be unsustainable under normal economic conditions.
  • With inflation spiking to its highest level since the 1980s, the central banks were forced to abandon their liberal monetary policies suddenly and hike interest rates in 2022 (to their highest levels since 2007) and curb the liquidity available in the economy via Quantitative Tightening.
  • It is unlikely that the central banks will be able to resort to these liberal policies again anytime soon, considering the core inflation now embedded in their economies.
  • In the absence of the support of bond prices by the central banks, market forces are now in control of interest rates in bond markets. They are now driving the yields to their historical norms as determined by risk and reward models (traditionally referred to as Capital Asset Pricing Models).
  • This “reversion to the mean” process of rates can sometimes be violent and disorderly, causing short-term stress in both stock and bond markets.
  • The mounting supply of bonds in the debt markets and sticky inflation will likely lead to higher yields on long-dated securiƟties for the foreseeable future
  • It appears that there is no appetite for expenditure control or curbing deficit spending in the US Congress now (both parties), and most likely, it will be financed by borrowing in the open markets by the treasury on a secular basis.
What is the investment strategy for building and preserving wealth now?
  • To be clear, the time horizon of a wealth management portfolio is long-term, meaning a three to five-year rolling window to achieve healthy inflation-adjusted returns. Owners of these assets need to inoculate themselves from the psychological impact of short-term volatility in the markets to achieve time compounding of wealth.
  • As the US economy adjusts to the new reality of higher inflation-adjusted (real) interest rates across the yield curve, capital preservation must take a higher priority for the foreseeable future in these portfolios.
  • Bonds, except for temporary rallies in response to economic conditions, are likely to face headwinds for the rest of the decade as the demand-supply equilibrium in the debt markets is achieved by the market forces in the face of sticky inflation and mounting debt issuance worldwide.
  • Under the scenario, high-quality equities with robust balance sheets and deep-moat earnings franchises that generate healthy cashflows must form the core of the portfolios to earn healthy inflation-adjusted returns.
  • Plenty of liquidity must be maintained in these portfolios to exploit fire-sale buying opportunities in asset classes such as commercial real estate and interest-sensitive equity sectors.
  • High inflation-adjusted interest rates will likely reduce the expected returns on equities across the board while valuations adjust to the new norm of discounting income streams at these rates. Traditional Dividend Discount Models might come in handy for equity purchasing decisions in the future.
  • The wealth owners must also learn to endure periods of volatility while the global capital markets adjust to the “new normal” market-driven interest rates and their relentless focus on earnings and cashflows of corporations.