What causes a bond bear market? Can it lead to sequence of returns risk?

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kiddoc
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What causes a bond bear market? Can it lead to sequence of returns risk?

Post by kiddoc » Thu Jan 09, 2020 7:33 pm

I am assessing the risk of my portfolio, specifically the bond part. I am aware of inflation risk, interest rate risk and credit risk. If someone like me holds funds containing intermediate term high grade bonds/ treasuries, a good helping of TIPS/I bonds, and holds them for longer than the duration of a single batch of bonds, what is the remnant risk?

As most people recommend moving more heavily into bonds close to retirement, I think this is a relevant question for sequence of returns risk. The history of bond market offers little guidance given the interest rate is so low. 2008 was more a stock market bear than a bond bear. Is that steep a decline fathomable for high grade bonds/ treasuries?
"The four most dangerous words in investing are: 'this time it's different.'" - Sir John Templeton

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patrick013
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Re: What causes a bond bear market? Can it lead to sequence of returns risk?

Post by patrick013 » Thu Jan 09, 2020 9:05 pm

The optimum strategy would be to lower maturities when interest rates are rising and expected to rise and increase maturities when interest rates are lowering and expected to decrease. So you would take advantage of the interest rate sensitivity of the bonds you own in the market and they would be more likely to experience capital gains.

Perfect information isn't always available and most rate movements have been up slightly and down slightly. Spiking rates up or down would produce more dramatic price movements. More likely rates will remain low with smaller than average spreads over the FFR.

Without any clearly defined strategy based on rate change possibilities ladders are a good option, target date bond funds are a good option, target dating expected expenses if in retirement with a 5 year ladder, can add structure to a low interest rate bond strategy. A tilt to LT treasuries can be volatile but add returns in the long term as bonds rise when rates go down and stocks are expected
to go down.

If rates were higher I wouldn't be laddering so much. I doubt I'll have any capital losses when I need
to withdraw.

Larry Swedroe has a good bond book and also the wiki has good bond information.

If rates were rising these bonds would be falling.

Image
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kiddoc
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Re: What causes a bond bear market? Can it lead to sequence of returns risk?

Post by kiddoc » Sat Jan 11, 2020 8:43 pm

patrick013, isn't that a market timing strategy designed to benefit from interest risk? Since perfect market timing/ interest risk prediction is not possible, won't it be better to just hold a fund beyond the maturity of the current bonds? I would assume the higher interest rate would make up for the drop in value when rates rise. Of course, to reduce sequence of returns risk, one can argue to shorten bond duration 5 years prior to retirement and then gradually increase duration of part of the bond portfolio after one eases into retirement.

So inflation, interest rate and credit risk can be countered reasonably. Any other threats to the "safe" part of our portfolio?
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Re: What causes a bond bear market? Can it lead to sequence of returns risk?

Post by Northern Flicker » Sat Jan 11, 2020 11:51 pm

Define what you mean by a bear market for bonds. Stocks are defined to have been in a bear market when there is a downdraft in nominal terms of 20% or more.

I don’t think there ever has been a bear market for treasuries if you use that definition. Inflation is the serious risk for nominal bonds, and there have been 20% downdrafts in real terms for nominal bonds.
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dbr
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Re: What causes a bond bear market? Can it lead to sequence of returns risk?

Post by dbr » Sun Jan 12, 2020 9:51 am

This discussion of what is a bond bear market might be helpful: https://awealthofcommonsense.com/2018/0 ... t-anyways/

To create a genuine sequence of returns risk from bonds one would have to be invested in a highly distorted portfolio of predominately long term bonds.

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Re: What causes a bond bear market? Can it lead to sequence of returns risk?

Post by jeffyscott » Sun Jan 12, 2020 10:59 am

dbr wrote:
Sun Jan 12, 2020 9:51 am
This discussion of what is a bond bear market might be helpful: https://awealthofcommonsense.com/2018/0 ... t-anyways/

To create a genuine sequence of returns risk from bonds one would have to be invested in a highly distorted portfolio of predominately long term bonds.
The conclusions there seem to make sense:
assume that a 10 percent loss in long-term bonds and a 5 percent loss in intermediate-term bonds constitute a bear market
and
the biggest risk to bond investors is the threat of rising inflation

TIPS and Ibonds would not really be affected by the second of those and worst case for intermediate term nominal bonds appears to have been maybe a 5-10% decline.
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Re: What causes a bond bear market? Can it lead to sequence of returns risk?

Post by Northern Flicker » Sun Jan 12, 2020 3:23 pm

When treasury interest rates rise without inflation it would be because of reduced demand for them. The rates can only rise so e measured amount before the increase in rates makes them more attractive and increases demand.
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Taylor Larimore
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Re: What causes a bond bear market?

Post by Taylor Larimore » Sun Jan 12, 2020 3:36 pm

kiddoc:

There is no "bond bear market" (a 20% decline) for mainstream bonds. The worst annual return for Vanguard Total Bond Market Index Fund was -2.66% in 1994. TBM gained +16.00% in 1995.

Best wishes.
Taylor
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Last edited by Taylor Larimore on Mon Jan 13, 2020 1:24 pm, edited 1 time in total.
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prioritarian
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Re: What causes a bond bear market?

Post by prioritarian » Sun Jan 12, 2020 3:53 pm

Taylor Larimore wrote:
Sun Jan 12, 2020 3:36 pm
There is no "bond bear market" (a 20% decline) for mainstream bonds. The worst annual return for Vanguard Total Bond Market Index Fund was -2.66% in 1944. TBM gained +16.00% in 1945.

This is also why concerns of a "bond bubble" really aren't justified.

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Forester
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Re: What causes a bond bear market? Can it lead to sequence of returns risk?

Post by Forester » Mon Jan 13, 2020 3:43 am

"In fact, long-term government bonds lost 60 percent of their value after inflation in a drawdown that lasted almost 50 years. Even five-year bonds were down more than 40 percent in real terms."

https://www.bloomberg.com/opinion/arti ... sses-alone

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Re: What causes a bond bear market? Can it lead to sequence of returns risk?

Post by nisiprius » Mon Jan 13, 2020 7:46 am

A data point on bond crashes in real life, and the degree to which some respected financial writers have exaggerated their likely severity.

(Assuming people are writing in good faith, my belief is that the risk is mostly risk to sophisticated institutional investors, who unwisely rely too much on the stability of bonds and use their usually-predictable behavior do financial engineering and create complex leveraged products).

In any case, in August, 2010, Jeremy Schwartz and Jeremy Siegel wrote an alarming article in The Wall Street Journal, entitled "The Great American Bond Bubble." Here's the rhetoric:
Ten years ago we experienced the biggest bubble in U.S. stock market history—the Internet and technology mania that saw high-flying tech stocks selling at an excess of 100 times earnings. The aftermath was predictable: Most of these highfliers declined 80% or more…. A similar bubble is expanding today that may have far more serious consequences for investors. It is in bonds, particularly U.S. Treasury bonds….
A casual reader might easily think that "far more serious consequences" than an 80% decline meant drawdown of more than 80% in bonds. But they don't actually say that. Here's their specific statement about severity, somewhat buried in the text, and not explicitly expressed as a percentage drawdown. (They leave it to the reader to notice that three times 2.8% is a lot less than 80%).
The possibility of substantial capital losses on bonds looms large. If over the next year, 10-year interest rates, which are now 2.8%, rise to 3.15%, bondholders will suffer a capital loss equal to the current yield. If rates rise to 4% as they did last spring, the capital loss will be more than three times the current yield.
So here's the thing. What they warned about really happened. Here's what interest rates did. They didn't actually hit 4%, but they rose way above 3.15%.

Image

Their warning came true. And here's a chart of Total Bond. And the actual decline really was in the neighborhood of "interest rate rise times duration." They were absolutely right. Can you find the place where the Great American Bond Bubble burst?

Source

Image

Some further thoughts.
  • Would it have been a good idea to sell all your Total Bond holdings the day after Schwartz and Siegel published "The Great American Bond Bubble?"
  • Would it have been a good idea to swap all your Total Bond holdings for a short-term bond fund in July, 2009, when a poster in this forum posted "Interest rates can only go up, why go intermediate in bonds?"
  • Would it have been a good idea to dump Total Bond in 1993 when Sir John Templeton stated "In general, we have thought that this very long bull market in bonds must be somewhere near the end?"
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Re: What causes a bond bear market? Can it lead to sequence of returns risk?

Post by patrick013 » Mon Jan 13, 2020 10:10 am

kiddoc wrote:
Sat Jan 11, 2020 8:43 pm
patrick013, isn't that a market timing strategy designed to benefit from interest risk? Since perfect market timing/ interest risk prediction is not possible, won't it be better to just hold a fund beyond the maturity of the current bonds?
The optimum strategy is just that. You could always do the opposite and reduced returns would be likely. When rates are above historical averages bond funds stay at their indexes. Ladders can buy LT until their average maturity is over 20 years. Or buy a specific LT bond index fund. The opposite strategy would be to stay shorter term. When rates are low interest rate sensitivity can cause some loss when rates start to rise. That's a market fact. There is no best bond portfolio that can prevent that. Low rates can be very dull and boring especially when more normal rates might crash or correct the equity market.
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Re: What causes a bond bear market? Can it lead to sequence of returns risk?

Post by alluringreality » Mon Jan 13, 2020 11:21 am

nisiprius wrote:
Mon Jan 13, 2020 7:46 am
Would it have been a good idea to sell all your Total Bond holdings the day after Schwartz and Siegel published "The Great American Bond Bubble?"
The article essentially supports dividend stock investing instead of buying treasuries, and total bond contains a considerable portion of treasuries. At this point the two ideas aren't even close regarding returns, so clearly the answer to this question with the intent of the authors is that yes it would have been a good idea to follow their suggestion by selling total bond. The article doesn't seem to spend many words going over expected differences in volatility between treasuries and dividend investing, and higher volatility is also clearly expected when choosing dividend stocks instead of treasuries, so the article doesn't really cover all reasons for holding treasuries. Similar to when the article was written, it's possible that current treasury rates could end up losing to inflation.
https://www.wsj.com/articles/SB10001424 ... 4002846058
https://www.indexologyblog.com/2019/01/ ... trategies/
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Re: What causes a bond bear market? Can it lead to sequence of returns risk?

Post by Scooter57 » Mon Jan 13, 2020 12:05 pm

The bond market after 2010 was supported by the Fed's very active, dramatic, and persistent intervention using an approach never before seen in financial markets, ever, which was not something anyone could know in 2010.

The 2010 article Nisi cites was written before Quantitative Easing became permanent, at a time when no one in finance expected the Fed's intervention to last beyond the originally described dates or swell to the levels it did (and stays at). So yes, no one predicted correctly what would happen, but what did happen has led to a level of debt, both government and corporate, never before seen, and a drop in the quality of that debt that is also unprecedented and whose implications have not yet played out.

The real risk to bonds is that at some point government intervention will not be enough to keep rates low after something occurs that makes investors realize that today's bonds are far more risky than the ones they grew up investing in. Bondholders (especially those holding via ETFs) attempting to dump bonds all at once could cause a rise in interest rates that has nothing to do with inflation, but more with lack of buyers for what are then perceived as dangerous investments.

Rising interest rates will send a lot of marginal companies ("zombie companies") into bankruptcy as they will no longer be able to refinance the huge amounts of debt that have kept them going. With half of all the bonds in Vanguard's Total Bond Market Index Fund at the lowest investment grade today, it is not hard to imaging a sudden shock caused by those bonds falling into "junk" status and significant numbers of them defaulting.

A bond bear market would be caused by defaulting bonds, no matter what inflation does.

Right now everything is held together by a possibly irrational belief that the Fed can control rates indefinitely and that they will keep rates suppressed. This is a belief, akin to the belief in an afterlife, that is widely held, but for which there is no substantive proof.

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Re: What causes a bond bear market? Can it lead to sequence of returns risk?

Post by jeffyscott » Mon Jan 13, 2020 12:21 pm

Scooter57 wrote:
Mon Jan 13, 2020 12:05 pm
With half of all the bonds in Vanguard's Total Bond Market Index Fund at the lowest investment grade today, it is not hard to imaging a sudden shock caused by those bonds falling into "junk" status and significant numbers of them defaulting.
I assume you meant 1/2 of the corporate bonds in the total bond index.
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Re: What causes a bond bear market?

Post by rasta » Mon Jan 13, 2020 12:36 pm

Taylor Larimore wrote:
Sun Jan 12, 2020 3:36 pm
kiddoc:

There is no "bond bear market" (a 20% decline) for mainstream bonds. The worst annual return for Vanguard Total Bond Market Index Fund was -2.66% in 1944. TBM gained +16.00% in 1945.

Vanguard was founded in 1975 I believe, so how could they have bond fund in 1944? What is the source for your data?

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Re: What causes a bond bear market? Can it lead to sequence of returns risk?

Post by jmk » Mon Jan 13, 2020 12:39 pm

Northern Flicker wrote:
Sat Jan 11, 2020 11:51 pm
Define what you mean by a bear market for bonds. Stocks are defined to have been in a bear market when there is a downdraft in nominal terms of 20% or more.

I don’t think there ever has been a bear market for treasuries if you use that definition. Inflation is the serious risk for nominal bonds, and there have been 20% downdrafts in real terms for nominal bonds.
There's been some close meeting that defintion, though, like july 1979 to feb 1980, 15.76% nominal drawdown on 10y treasury.

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Last edited by jmk on Mon Jan 13, 2020 5:21 pm, edited 2 times in total.

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Taylor Larimore
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My mistake

Post by Taylor Larimore » Mon Jan 13, 2020 1:21 pm

taylor wrote:There is no "bond bear market" (a 20% decline) for mainstream bonds. The worst annual return for Vanguard Total Bond Market Index Fund was -2.66% in 1944. TBM gained +16.00% in 1945.
rasta wrote:Vanguard was founded in 1975 I believe, so how could they have bond fund in 1944? What is the source for your data?
rasta:

Thank you for catching my mistake in dates. I will edit my post to change "1944" to "1994". Morningstar was my source.

Best Wishes
Taylor
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Re: What causes a bond bear market? Can it lead to sequence of returns risk?

Post by nisiprius » Mon Jan 13, 2020 3:17 pm

When you say that the events Schwartz and Siegel warned against would have occurred had it not be for Fed actions "never before seen," you are missing the point. They did occur. The predictions/warnings made in the 2010 article were spot on and were fulfilled. Interest rates did what they said they would do. The effect was the effect they said they would have. Whatever the Fed did after that was unrelated. The only thing wrong about the article was the exaggerated rhetoric that suggested if it happened, the consequences would be comparable to that of the high-tech stock bubble collapse.

What they predicted or warned against has actually happened many times before and since, and bond prices responded each time according to bond math, before and since.

Image

Now, perhaps you are suggesting that without the Fed's "approach never before seen," interest rates, instead of stopping at 3.73% would have done this:

Image

--but that is not what Schwartz and Siegel said.

In any case, they mentioned an 80% decline in stocks, in their opening paragraph, so let's ask: Suppose you put $10,000 in a simulated bond ladder without about the same duration as Total Bond. Assume we start at an interest rate of 2%. During the "bond bubble collapse" interest rates rose by about 1.2% in three months, so call that 5% per years: assume interest rates begin rising at 5% per year.

What interest rate rise would it it take to knock 80% off the balance in our account, cut our balance down to $2,000?

The answer, interestingly, is that it cannot happen with a rate of rise of 5% per year. The accumulation of coupon interest and the "pull to maturity" in bond values become so large that they balance the effect of rising rates and the sag actual stops and reverses, long before the balance sinks to $2,000.

Image

Even if we throw away the coupon interest payments a rise of 5% per year is still not enough to knock -80% off the price of bonds with 6.2-year duration.

Image

Certainly, if we are limited only by our imagination we can imagine scenarios was bad as we like: massive defaults of every kind of bond, or Venezuelan-scale hyperinflation, the US adopting the Thai baht as its national currency...

But my point was exaggeration of consequences. Everything Schwartz and Siegel warned of as a possibility actually happened, and yet the consequences were not the disaster they implied. In fact many people didn't even notice it. Not because the Fed stopped it, but because an interest rate rise from 2.8% to 3.73% does not make bond funds drop by 80%.
Last edited by nisiprius on Mon Jan 13, 2020 9:49 pm, edited 1 time in total.
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Re: What causes a bond bear market? Can it lead to sequence of returns risk?

Post by Scooter57 » Mon Jan 13, 2020 9:22 pm

jeffyscott wrote:
Mon Jan 13, 2020 12:21 pm
Scooter57 wrote:
Mon Jan 13, 2020 12:05 pm
With half of all the bonds in Vanguard's Total Bond Market Index Fund at the lowest investment grade today, it is not hard to imaging a sudden shock caused by those bonds falling into "junk" status and significant numbers of them defaulting.
I assume you meant 1/2 of the corporate bonds in the total bond index.
Yes. It's half of the corporate bonds in the fund and 19% of the fund as a whole, which is still quite troubling.

It isn't possible to discuss factors affecting the quality of treasury bonds without veering into forbidden political discussions, but geopolitical events can affect the desire or ability of foreign countries and nationals to buy US treasury offerings. A case could be made that the quality of treasury bonds isn't what it was 20 years ago...

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