Corporate & Treasury Bonds: Where's the risk?

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charleshugh
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Corporate & Treasury Bonds: Where's the risk?

Post by charleshugh » Tue Dec 05, 2017 8:53 pm

"The risks from a big stock or bond market drop ‘are high and rising,’ government watchdog says"
https://www.marketwatch.com/story/the-r ... s-2017-12-

I don't understand the risk aspects of corporate bonds and treasury bonds.
I get that bonds are interest rate sensitive but outside of a bond defaulting, where is the "existential" danger? How bad could it get?
Assuming that I have $100,000 in corporate bonds and $100,000 in Treasury bonds, how much could I realistically lose?
Treasury bonds are backed by U.S. government. And if I am holding "A" rated corporate bonds, where is the risk (other than a reduced ROI)?

Thank you for your perspective.

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Kevin M
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Re: Corporate & Treasury Bonds: Where's the risk?

Post by Kevin M » Tue Dec 05, 2017 9:09 pm

Your link didn't work for me, but I found this M* article that quotes the same report: UPDATE: The risks from a big stock or bond market drop 'are high and rising,' government watchdog says.

Here is a relevant exerpt:
In the bond market, sensitivity of bond prices to interest rate moves has steadily increased since the crisis, the report said.

In early 2017, the duration of the Barclays U.S. Aggregate Bond Index reached an all-time high of just over six years.

At current levels of duration, a 1 percentage point increase in interest rates would lead to a decline of almost $1.2 trillion in the securities underlying the index.

And that estimate understates the potential losses as the index does not include high-yield bonds, fixed-rate mortgages and fixed income derivatives.

"A sudden decline in bond prices would lead to significant distress for some investors, particularly those that are highly leveraged," the report said.
So the point basically is that the duration of the aggregate US bond market is historically high, so the downside risk to the overall bond market due to a relatively large increase in yields is historically high. I wouldn't characterize this as an "existential risk", and the M* article did not use this term.

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Re: Corporate & Treasury Bonds: Where's the risk?

Post by triceratop » Tue Dec 05, 2017 9:47 pm

charleshugh wrote:
Tue Dec 05, 2017 8:53 pm
"The risks from a big stock or bond market drop ‘are high and rising,’ government watchdog says"
https://www.marketwatch.com/story/the-r ... s-2017-12-

I don't understand the risk aspects of corporate bonds and treasury bonds.
I get that bonds are interest rate sensitive but outside of a bond defaulting, where is the "existential" danger? How bad could it get?
Assuming that I have $100,000 in corporate bonds and $100,000 in Treasury bonds, how much could I realistically lose?
Treasury bonds are backed by U.S. government. And if I am holding "A" rated corporate bonds, where is the risk (other than a reduced ROI)?

Thank you for your perspective.
Even if a bond does not go into default its price that can be obtained on the open market may fluctuate due to market expectations of default likelihood. That is risk. Importantly, these price moves may be highly correlated (or not!) with equity price risk, which limits the diversification benefit of bonds. An easy way to see this is to compare the return of a total bond fund to an intermediate treasury fund in the 2008 crisis. The total bond fund had treasuries to be sure but also plenty of corporate bonds.
"To play the stock market is to play musical chairs under the chord progression of a bid-ask spread."

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Re: Corporate & Treasury Bonds: Where's the risk?

Post by alex_686 » Tue Dec 05, 2017 10:04 pm

Kevin M wrote:
Tue Dec 05, 2017 9:09 pm
So the point basically is that the duration of the aggregate US bond market is historically high, so the downside risk to the overall bond market due to a relatively large increase in yields is historically high. I wouldn't characterize this as an "existential risk", and the M* article did not use this term.
It is not that the duration is historically high. The duration you see posted on mutual funds is a measure of time. It is that for a given duration the yields are low.

For treasuries the real yield - yield after expected inflation - is low but not rock bottom. The problem here is that expected inflation is expected to be very low over the next 10 years - something slightly above 2% IIRC. Many consider this optimistic. This is one time bomb ready to go off.

For coporates the issues is the above treasury issue but the credit spread. The credit spread is the extra yield you get in investing in risky securities. This is at historic lows. So lower return for the same level or risk. Once again, very optimstic pricing.

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Re: Corporate & Treasury Bonds: Where's the risk?

Post by Grt2bOutdoors » Tue Dec 05, 2017 10:16 pm

triceratop wrote:
Tue Dec 05, 2017 9:47 pm
charleshugh wrote:
Tue Dec 05, 2017 8:53 pm
"The risks from a big stock or bond market drop ‘are high and rising,’ government watchdog says"
https://www.marketwatch.com/story/the-r ... s-2017-12-

I don't understand the risk aspects of corporate bonds and treasury bonds.
I get that bonds are interest rate sensitive but outside of a bond defaulting, where is the "existential" danger? How bad could it get?
Assuming that I have $100,000 in corporate bonds and $100,000 in Treasury bonds, how much could I realistically lose?
Treasury bonds are backed by U.S. government. And if I am holding "A" rated corporate bonds, where is the risk (other than a reduced ROI)?

Thank you for your perspective.
Even if a bond does not go into default it's price that can be obtained on the open market may fluctuate due to market expectations of default likelihood. That is risk. Importantly, these price moves may be highly correlated (or not!) with equity price risk, which limits the diversification benefit of bonds. An easy way to see this is to compare the return of a total bond fund to an intermediate treasury fund in the 2008 crisis. The total bond fund had treasuries to be sure but also plenty of corporate bonds.
^^That depends if you can actually get a price. In the 2008/2009 debacle, many fixed income securities had no price or if they did have a price they were receiving bids that were showing markdowns of 30-50%+ from last known quotation. In essence, there was a run on liquidity, short of holding cash and/or extremely short-term (7 days or less) Treasuries, many securities which were previously rated in the top 5 rungs of ratings were being marked down with noticeable haircuts, those rated lower were being bid at firesale prices if you could obtain a quote. You know the saying "cash is king", well that liquidity crunch proved it. It all came down to trust, and there was very very little of it to go around. GE did not default at any time (was rated AAA at the time before the downgrade), yet it could not raise cash in the commercial paper market, even with a rating of A-1 it was having trouble refinancing existing and new debt to finance its operations.

If you want to see how bad it could get take a look at "investment grade intermediate term bond, corporate investment grade bond fund only - many of which hold 50%+ of BBB+ rated paper, look at true high yield debt fund. Some high yield debt funds hold better quality securities than others. Then look at mortgage backed securities only funds - you know what the value of bonds are when you know what the value of underlying mortgages are worth, only guess what? the ratings of underlying mortgages for some tranches weren't worth the paper they were written on.
Last edited by Grt2bOutdoors on Tue Dec 05, 2017 10:23 pm, edited 1 time in total.
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Re: Corporate & Treasury Bonds: Where's the risk?

Post by Grt2bOutdoors » Tue Dec 05, 2017 10:21 pm

alex_686 wrote:
Tue Dec 05, 2017 10:04 pm
Kevin M wrote:
Tue Dec 05, 2017 9:09 pm
So the point basically is that the duration of the aggregate US bond market is historically high, so the downside risk to the overall bond market due to a relatively large increase in yields is historically high. I wouldn't characterize this as an "existential risk", and the M* article did not use this term.
It is not that the duration is historically high. The duration you see posted on mutual funds is a measure of time. It is that for a given duration the yields are low.

For treasuries the real yield - yield after expected inflation - is low but not rock bottom. The problem here is that expected inflation is expected to be very low over the next 10 years - something slightly above 2% IIRC. Many consider this optimistic. This is one time bomb ready to go off.
The best time to buy insurance is when no one expects a calamity to occur. Buying TIPs, commodities is one way to partially hedge bet. Normally folks would say buy real estate, but real estate is priced for perfection - take away the punch bowl and they may have a nasty hangover.

For coporates the issues is the above treasury issue but the credit spread. The credit spread is the extra yield you get in investing in risky securities. This is at historic lows. So lower return for the same level or risk. Once again, very optimstic pricing.
If equities markets adjust, corporate bonds will follow, but that depends on a significant drop-off in corporate profitability. If that were to occur, I would have to believe the pre-cursor to that is a wide and deep recession. I don't see that happening through my rose colored glasses.
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Re: Corporate & Treasury Bonds: Where's the risk?

Post by mega317 » Wed Dec 06, 2017 12:15 am

Nisiprius had a nice post in a recent thread

viewtopic.php?t=232550#p3623791

and showed that even a bond "massacre" barely registers in terms of actual losses. (I hope I understood his point.)

So yes there's risk but I think the answer to "how bad can it get" is "not really that bad".

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Re: Corporate & Treasury Bonds: Where's the risk?

Post by Grt2bOutdoors » Wed Dec 06, 2017 7:15 am

mega317 wrote:
Wed Dec 06, 2017 12:15 am
Nisiprius had a nice post in a recent thread

viewtopic.php?t=232550#p3623791

and showed that even a bond "massacre" barely registers in terms of actual losses. (I hope I understood his point.)

So yes there's risk but I think the answer to "how bad can it get" is "not really that bad".
Depends, if one holds individual issues and panics, can be a totally different story.
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Re: Corporate & Treasury Bonds: Where's the risk?

Post by Doc » Wed Dec 06, 2017 7:17 am

Corporate bonds sometimes (often?) have call provisions.
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Re: Corporate & Treasury Bonds: Where's the risk?

Post by bondsr4me » Wed Dec 06, 2017 7:25 am

Doc wrote:
Wed Dec 06, 2017 7:17 am
Corporate bonds sometimes (often?) have call provisions.
+1

That is one of the first things I look at before considering buying a bond. Fidelity shows this on their bond screen.

Don

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Re: Corporate & Treasury Bonds: Where's the risk?

Post by jhfenton » Wed Dec 06, 2017 8:25 am

Doc wrote:
Wed Dec 06, 2017 7:17 am
Corporate bonds sometimes (often?) have call provisions.
Indeed. Often with so-called "make whole" provisions if called before a certain date. Make whole provisions typically pay the Net Present Value of future lost coupon payments (or a defined portion of lost coupon payments) discounted by a defined rate, usually comparable a comparable treasury plus a spread (e.g. 40 bp).

One bond I pulled up was for 10 years, issued in 2011, maturing in 2021, callable starting in 2016 with a make-whole provision if called before 2019, calculated as lost coupon payments through 2019 discounted by a comparable treasury rate plus 50 bp.

You can pretty much guarantee that any newly-issued high-yield (non investment grade) bond is going to have a call provision that would allow the company to take advantage of an improving credit situation. It's a heads-they-win-tails-you-lose situation.

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Re: Corporate & Treasury Bonds: Where's the risk?

Post by Doc » Wed Dec 06, 2017 9:14 am

jhfenton wrote:
Wed Dec 06, 2017 8:25 am
You can pretty much guarantee that any newly-issued high-yield (non investment grade) bond is going to have a call provision that would allow the company to take advantage of an improving credit situation. It's a heads-they-win-tails-you-lose situation.
That's similar reasoning to the situation with TIPS MBS where the individual mortgagees have similar choices to prepay or extend depending on interest rate changes.
Last edited by Doc on Wed Dec 06, 2017 11:06 am, edited 1 time in total.
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Re: Corporate & Treasury Bonds: Where's the risk?

Post by Valuethinker » Wed Dec 06, 2017 9:45 am

Doc wrote:
Wed Dec 06, 2017 9:14 am
jhfenton wrote:
Wed Dec 06, 2017 8:25 am
You can pretty much guarantee that any newly-issued high-yield (non investment grade) bond is going to have a call provision that would allow the company to take advantage of an improving credit situation. It's a heads-they-win-tails-you-lose situation.
That's similar reasoning to the situation with [EDIT: changed to MBS which makes my comment unnecessary] where the individual mortgagees have similar choices to prepay or extend depending on interest rate changes.


TIPS do not have that property. They are just US Treasury bonds, but indexed to inflation.

US Mortgage Backed Securities (MBS) do-- extension or repayment risk arising out of the flexibility granted to borrowers. MBS from other countries generally do not.

MBS not TIPS ;-).
Last edited by Valuethinker on Wed Dec 06, 2017 12:47 pm, edited 1 time in total.

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Re: Corporate & Treasury Bonds: Where's the risk?

Post by triceratop » Wed Dec 06, 2017 9:50 am

mega317 wrote:
Wed Dec 06, 2017 12:15 am
Nisiprius had a nice post in a recent thread

viewtopic.php?t=232550#p3623791

and showed that even a bond "massacre" barely registers in terms of actual losses. (I hope I understood his point.)

So yes there's risk but I think the answer to "how bad can it get" is "not really that bad".
That post is only nominal returns. One should look at real returns, which is in terms of actual purchasing power, and instead in the 1970s and 1980s. Fortunately with Simba's backtesting sheet we can do exactly that. It isn't pretty.
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Re: Corporate & Treasury Bonds: Where's the risk?

Post by randomizer » Wed Dec 06, 2017 10:13 am

Grt2bOutdoors wrote:
Wed Dec 06, 2017 7:15 am
mega317 wrote:
Wed Dec 06, 2017 12:15 am
Nisiprius had a nice post in a recent thread

viewtopic.php?t=232550#p3623791

and showed that even a bond "massacre" barely registers in terms of actual losses. (I hope I understood his point.)

So yes there's risk but I think the answer to "how bad can it get" is "not really that bad".
Depends, if one holds individual issues and panics, can be a totally different story.
Could the same thing happen in an index fund if enough people panic and run for the exits? I would expect the effects to accumulate and pass through to a degree.

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Re: Corporate & Treasury Bonds: Where's the risk?

Post by dbr » Wed Dec 06, 2017 10:44 am

1. Bond risk is not in the same ballpark as stock risk. Speaking the two in the same sentence is terribly misleading.

2. In the popular press bonds usually means long term bonds, which are the riskiest bonds both to interest rate changes and to inflation (except TIPS), and the risk is still less than that of stocks. Note the actual language was "A sudden decline in bond prices would lead to significant distress for some investors, particularly those that are highly leveraged . . . " If that is you, you probably are aware of it.

It is a good idea to learn all about the actual risks in bonds, the chief of which is they don't earn enough return to enable an investor to meet his objectives unless those objectives don't require a lot of return (duh!). A second risk is that investors that for some reason need an asset that is "safe" usually have a notion of what that means that most bonds don't meet. What is your idea of "safe" or do you care?

Larry Swedroe has a pretty good book on bonds: https://www.amazon.com/Only-Guide-Winni ... droe+bonds

An aside is that I believe Larry once said he didn't care for the "Winning Strategy" part of the title and that came from the publisher. Whether I have that right or not, Larry does not write from a point of view of "beating the market."

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Re: Corporate & Treasury Bonds: Where's the risk?

Post by Doc » Wed Dec 06, 2017 11:07 am

Valuethinker wrote:
Wed Dec 06, 2017 9:45 am
Doc wrote:
Wed Dec 06, 2017 9:14 am
jhfenton wrote:
Wed Dec 06, 2017 8:25 am
You can pretty much guarantee that any newly-issued high-yield (non investment grade) bond is going to have a call provision that would allow the company to take advantage of an improving credit situation. It's a heads-they-win-tails-you-lose situation.
That's similar reasoning to the situation with TIPS where the individual mortgagees have similar choices to prepay or extend depending on interest rate changes.


TIPS do not have that property. They are just US Treasury bonds, but indexed to inflation.

US Mortgage Backed Securities (MBS) do-- extension or repayment risk arising out of the flexibility granted to borrowers. MBS from other countries generally do not.

MBS not TIPS ;-).
:oops: Thanks, edited prior post.
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Re: Corporate & Treasury Bonds: Where's the risk?

Post by garlandwhizzer » Wed Dec 06, 2017 12:58 pm

triceratop wrote:
That post is only nominal returns. One should look at real returns, which is in terms of actual purchasing power, and instead in the 1970s and 1980s. Fortunately with Simba's backtesting sheet we can do exactly that. It isn't pretty.
1+

The real risk in bonds is inflation. We have been in a very low inflation environment for more a decade which followed a multi-decade period of ever decreasing inflation and interest rates. Bonds do well in real and nominal terms under such circumstances which is why so many of us, having become accustomed to this, equate bonds with both attractive real returns and safety. Old people like Warren Buffett (and, unfortunately, me) remember the 60s, 70s, and 80s when inflation rose consistently and gained considerable momentum. It fed on itself and grew. Those who weren't investing then never experienced what it was like and tend not to consider it.

As Bernstein has said, there are two kinds of risk, shallow risk like you get with bear market equity, devastating when it happens but generally of shorter duration, years or a maybe a decade or so, under the worst circumstances. If you held on to stocks in the Great Depression and re-invested dividends you were made whole in well less than a decade in real terms. Likewise with the financial collapse of 2007-9. The other and greater type of risk is deep risk which is usually due to inflation and is most severe in the bond market. Those who consistently bought and held ten year Treasuries, turning them over when mature, for the 40 years between 1940 - 1980 suffered considerable real losses for the entire 4 decades. Yes, 4 consecutive decades of negative real returns, the type of risk that totally wipes your bond heavy portfolio out although it does it a little at a time.

Nisi likes to show charts of how well bonds due during a bond crisis in nominal terms, but it's important to keep in mind that you have to spending real dollars on a day to day basis not nominal dollars that have lost considerable spending power. Make no mistake, bonds have risk. IMO their biggest risk now when no one worries about inflation is unforeseen future inflation risk especially in long duration bonds. Nominal bonds are much less volatile than stocks, easier to emotionally tolerate their ups and downs, but they they can still devastate your portfolio. They do it not with a sudden thrust of the sword like stocks, but instead with a million paper cuts over a long period of ever increasing inflation.

Wise to keep both bonds and stocks in significant proportions in a portfolio IMO.

Garland Whizzer

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Re: Corporate & Treasury Bonds: Where's the risk?

Post by Grt2bOutdoors » Wed Dec 06, 2017 6:52 pm

randomizer wrote:
Wed Dec 06, 2017 10:13 am
Grt2bOutdoors wrote:
Wed Dec 06, 2017 7:15 am
mega317 wrote:
Wed Dec 06, 2017 12:15 am
Nisiprius had a nice post in a recent thread

viewtopic.php?t=232550#p3623791

and showed that even a bond "massacre" barely registers in terms of actual losses. (I hope I understood his point.)

So yes there's risk but I think the answer to "how bad can it get" is "not really that bad".
Depends, if one holds individual issues and panics, can be a totally different story.
Could the same thing happen in an index fund if enough people panic and run for the exits? I would expect the effects to accumulate and pass through to a degree.
Not as likely since index fund is quite diversified amongst issues and types. Fund also has investors exiting and entering the fund, fund may also have access to credit lines that can be used as liquidity thereby negating the need to liquidate at an inopportune time.
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Re: Corporate & Treasury Bonds: Where's the risk?

Post by Thesaints » Wed Dec 06, 2017 6:56 pm

Corporate bonds can and do default, even those with the highest rating. Of course, higher ratings are less likely to do so.

Treasury bonds, the risk is raising inflation eating on your capital and interest. Essentially, only long term issues are affected substantially but ask those who bought 10-year notes at 7% in '74.

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Re: Corporate & Treasury Bonds: Where's the risk?

Post by Kevin M » Wed Dec 06, 2017 10:40 pm

alex_686 wrote:
Tue Dec 05, 2017 10:04 pm
Kevin M wrote:
Tue Dec 05, 2017 9:09 pm
So the point basically is that the duration of the aggregate US bond market is historically high, so the downside risk to the overall bond market due to a relatively large increase in yields is historically high. I wouldn't characterize this as an "existential risk", and the M* article did not use this term.
It is not that the duration is historically high. The duration you see posted on mutual funds is a measure of time. It is that for a given duration the yields are low.
Apparently you did not read the article, or even the part of it that I quoted.

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Re: Corporate & Treasury Bonds: Where's the risk?

Post by Johnnie » Thu Dec 07, 2017 1:29 pm

Bill Gross is saying bond risk represented by a spike in rates is so great now that bonds may not protect portfolios in a big equity downdraft:

“Risk assets, therefore, have a less ‘insurable’ left tail that should be priced into higher risk premiums. Should a crisis arise because of policy mistakes, geopolitical crises, or other currently unforeseen risks, the ability to protect principal will be impaired relative to history.”

I know - Bill Gross says lots of things. Sometimes he's even right. (Cue my signature line.)

Via MarketWatch, quoting Gross's latest newsletter.
https://www.marketwatch.com/story/bill- ... 2017-12-07
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