Investors would be hit with losses of more than 15 per cent on some bonds if yields rose by the same magnitude as they did in 1994, according to M&G’s Anthony Doyle, while Rowan Dartington Signature’s Guy Stephens warns that a fall in bonds is now “a mathematical certainty”.
Bonds have had a strong run over the eight years of the market cycle, as investors flocked to perceived safe havens after the financial crisis and unprecedented quantitative easing programmes by the world’s central banks pushed down yields to record lows.
Performance of indices over 8yrs
Source: FE Analytics
The asset class is now viewed by many as expensive and some – including the US bond guru Bill Gross – have been forthcoming in warning that the 30-year bull market in fixed income could be approaching its end.
Turbulence in the bond market has caught investors’ attention in recent weeks, especially when it comes to German bunds.
Although usually seen as a safe-haven, bunds have been hit by a spike in volatility and holders of 30-year bunds would have faced capital losses of around 15 per cent after yields moved from around 0.50 per cent to 1.15 per cent.
Bond investors are now concerned that significant falls could occur in other parts of the market.
Doyle, an investment director in M&G’s fixed-income team, said: “Since 1986, government bond investors have lost money in three calendar years. The magnitude of those losses is as follows: -3.1 per cent (1994), -0.8 per cent (1999) and -0.4 per cent (2013).”
“The reason that total returns have rarely been negative is because investors were receiving relatively high coupons and had a significant income cushion to protect against any capital downside.”
However, he pointed out that the low yields on offer in many parts of the bond market mean this is unlikely to be the case in the future: “These days, total returns in government bond markets will largely be a function of capital movements, with income providing little support in a bear market for government bonds.”
Looking at drawdowns experienced by different types of bonds in the past and can be useful in working out how they will perform in different market conditions, Doyle adds.
For example, during the bond bear market of 1994 government bonds lost 5 per cent. However, this is the only time government bonds have posted a maximum drawdown of this scale over the past 29 years; since 1986 the average maximum drawdown per calendar year for these assets has only been 1.5 per cent.
Investment-grade bonds, on the other hand, witnessed a 10 per cent maximum drawdown in 2008 because many were issued by the banks that were at the centre of the financial crisis. Since 1997, their average maximum drawdown has been 1.9 per cent.
High-yield corporate bonds, with their greater correlation to equities and higher volatility than the other main bond sectors, have put their investors through a rougher ride. Doyle points out that high-yield bonds have seen a maximum drawdown of more than 5 per cent on six occasions since 1998, with the average annual maximum drawdown being 5.6 per cent.
“It is possible to model (with some simplifying assumptions, like any move in rates is a one-off shock and the yields rise across the curve by the same amount and no move in currencies) for any movements of bond yields and corporate bond spreads and compare to the historic return profile for fixed income,” he said.
“It is simplistic but is useful as a rough guide to highlight the impact that lower yields could have on fixed income total returns.”
If government bond yields and corporate bond spreads do not change and investors receive the current yield to maturity on the fixed income asset classes, then global government bonds can be expected to post a 12-month total return of 1 per cent, investment-grade 2.5 per cent and high-yield 6 per cent.
But if government bond yields increased by 1 per cent and credit spreads remained stable, only high-yield bonds would be in positive territory over one year – and the gain here would only be 1.8 per cent. Government bonds would fall 6.6 per cent, while investment-grade’s losses would be 4 per cent.
During the 1994 sell-off, the yield on the global government bond index rose 219 basis points. A move of that magnitude today, with no change in credit spreads, would cause government bonds to plummet 15.5 per cent, investment-grade by 11.7 per cent and high-yield by 3.2 per cent.
Performance of index during 1994
Source: FE Analytics
Even more worrying, Doyle warns that the above losses would look “optimistic” if corporate bond spreads were to rise in tandem with higher government bond yields.
Of course, there are reasons to hold bonds even in the current environment – not least the diversification benefits they offer a portfolio full of equities and a steady stream of income, despite the low yields.
The investment director also says there is a chance that government bond yields may not increase to levels seen a couple of years ago thanks to high global debt levels, structural deflationary forces and the global savings glut, which would limit their losses.
But Doyle adds that there is an argument that the risk of a loss from government bonds “have never been greater” due to the global collapse in yields and it would not take much upward movement in yields for investors to be hit with a record drawdown.
“The collapse in yields across the fixed income spectrum now means that investors are at greater risk of higher drawdowns than ever before, and the income component of their total return is unlikely to adequately compensate for any hits to capital returns like it would in the old days,” he said. 
Rowan Dartington Signature’s Guy Stephens (pictured) agrees that the risks facing bond funds are significant and says the falls over recent week have done little to improve the outlook.
“We think the bond markets still look very expensive and with economic growth remaining robust, there are likely to be interest rate rises this year. It is therefore a mathematical certainty that investors will lose money,” he said.
“The reason why the market is not already pricing this in is that we have a huge distortion via the ECB QE just as we did in the US, UK and Japanese bond markets. There is therefore a risk that we could see a ‘taper-tantrum’ style wobble in bond markets when the likelihood of a change in direction on interest rates becomes a near certainty.”
Stephens compares today’s fixed income market to the technology bubble of the late 1990s. Some investors started to worry about valuations in the summer of 1998, prompting a 23 per cent fall in the stocks.
However, they went on to rally another 43 per cent before the bubble eventually burst at the end of 1999.
“Investors had lived with the elevated valuations for so long that they then failed to recognise that the business environment had changed, buying into the weakness thinking there was another 43 per cent to be had. Such is the greed trait of human behaviour,” Stephens concluded.
“The question is, could we be seeing the same in the bond markets? Have we lived with over-valuation for so long and the threat of interest rate rises and inflation, both of which have failed to materialise, that we will fail to correctly price them in when we should, which will mean initial complacency followed by denial and then panic.”
“Clearly, the authorities will do their utmost to maintain calm markets but in doing this, they are putting off the day when they raise rates for as long as possible, when arguably they should already have moved.”
