DPAM Blog

STATE OF AFFAIRS

• • In order the give a proper answer to the question in the title, we need to define a bond bear market. And here we immediately are confronted with the lack of any standard, generally accepted definition. In equity markets, a bear market becomes newspaper headline stuff the moment a correction moves across the 20% threshold. In bond markets some commentators call for a bond bear the moment long term bonds with maturities above 20 years fall by more than 10% and intermediate bonds with maturities between 5 and 10 years fall by 5%. Long-term US Treasury bonds fit the bill. Over Q1 2021, expressed in USD, the long end of the market dropped by 14.13%. However, the intermediate part for US Treasuries adjusted by 3.15%, whereas intermediate corporates fell 4.23%. In Europe, we observe a similar picture for core 30-year EMU government bonds like Germany and France that retreated around 11%. However, 30-year Italian BTP’s fell back a mere 4.5%. So, for investors that were ‘only’ exposed to long-maturity nominal US or core European government bonds, we can say that we entered a bear market. Intermediate solutions, which constitute the bulk of bond portfolios, are not in bear territory. Anno 2021, we are going through a bear-steepener sell-off in rates. These are the most dangerous, as well as the most difficult ones to overcome. Dangerous in the sense that investors easily lose their nerve and start mixing up return profiles across bond sectors. Some bond sectors can hold their value better or even thrive when other sectors fall victim to bear conditions. Difficult in the sense that an aggressive sell-off in long term bonds (30-year bonds for instance) cause short-term pain. However, the moment rates consolidate, and momentum turns positive again (rates go down), these sections of the bond market can properly boost returns. The adagio that we are all aware of in equity markets (i.e. that one cannot miss the early equity recovery episodes in order to generate decent long-term results) is also present at the long end of yield curves.

• • Let’s dig a bit deeper into the bear market analogy and look at broad, aggregate indices. We compare the Bloomberg Barclays US Aggregate Total Return index with the Bloomberg Barclays Euro Aggregate Total Return index. The US Aggregate index has a market value of about USD 25 trillion whereas the Euro Aggregate index represents EUR 13.2 trillion of government, government-like, agency and investment grade (IG) corporate debt instruments. Over Q1 2021, the US Aggregate declined by 3.37% in USD terms, the Euro Aggregate lost 1.9%. Interestingly, one must go back to Q3 1981 in order to find a higher negative quarterly return. Q3 1981 posted a -4.07% result. The US Aggregate index that was launched in 1976, saw its worst quarters over Q1 and Q3 1980, posting returns of -8.71% and -6.56% respectively. Back then, the US 30-year long bond saw a maximum drawdown of almost 21%. The maximum adjustment for 5-year Treasuries reached almost 9%. The 1969-1970 bear market was similar in intensity for long maturity bonds, but less so for intermediate bonds. Anyway, US bond investors had to look back 40 years for such a bad quarter! One can state that the bond bear in the US is awake and well. The Euro Aggregate declined by 1.90% over Q1 2021. Since its launch back in 1998, this broad index has posted 5 quarters with a negative return of more than 2%. The one we remember best was Q2 2015: the infamous Bund VaR shock, when 10-year German rates went from close to 0.00% mid-April 2015 towards 1.00% by mid-June. Over Q2 2015, the Euro Aggregate index fell 4.35%. Today the US Aggregate has a yield of 1.56%, whereas the Euro Aggregate has a yield of 0.04% for duration profiles of 7.7 years and 6.5 years respectively. All-in-all, the damage has been limited so far. The moment investors complement core bond exposures with inflation-linked bonds, pure IG or high yield (HY) solutions and Emerging Market (EM) government exposure, the results brighten up even more. So, history has proven that nominal drawdowns are temporary. Over time, nominal return setbacks in bonds will disappear. However, the biggest enemy is the loss of purchasing power over the long-term due to inflation.

• • Taking long-term inflation-adjusted or real US government returns on 5-year bonds and 30-year bonds, the picture is somewhat sobering. Between early 1940’s and 1981, US 5-year bonds were down 40% in real terms. Long-term 30-year US Treasuries lost 60% of their value after inflation over a 40-year period. In the early 1940s, the US FED entered into a regime of yield curve control, capping 10-year to 30-year US rates at 2.5%. That was abandoned by 1951. The first true bear US bear market was encountered by 1969-1970. Long bond rates peaked just above 15% in 1981. The astonishing loss of value was a result of an average US CPI of 4.8% over that 40-year era. Currently US CPI YoY sits at 1.7%. We can expect that over Q2 we will see high volatility in readings that can range between 2.5% to 3.50%. Over H2 2021 US CPI should return towards 2.00-2.50%. That is consensus. But what is striking is that 4.8% is not that far from 2.00% to 3.00%, on average. Bond investors need to remain extremely vigilant over the next 2 to 3 years. Clearly the fiscal-monetary entente has kicked off a new market regime. Back in the days, between 1941 and 1951, the FED simply capped rates, even under conditions that saw very high inflation after 1945. Today, the FED has launched Average Inflation Targeting. An experiment that has not been tested. The 5Y5Y forwards in US Treasuries moved above 2.5%. This is an attractive investment level, if the FED can honour their 2% inflation objective. It becomes a completely different ballgame if the anchor comes loose, and average inflation rise to 3%. Let’s not go into a scenario of 4%…levered financial markets would enter a historically-unseen bear market across asset classes.