How Low Rates Set the Stage for a Bond-Market Massacre

After the stock market's huge rise over the past four years, investors are understandably concerned about just how far the market could fall in an ordinary correction from current levels. But what many investors don't fully comprehend is the potential for substantial capital losses in the bond market. Low interest rates are what created that danger, and the carnage we've seen so far among bonds is just the tip of the iceberg if rates revert to more typical long-term levels.

Getting some perspective
Even with yesterday's extensive losses, the stock market hasn't really given up any substantial amount of ground from its recent highs. Over the past month, the S&P 500 has lost less than 2.5%, and the Dow remained within 300 points of its all-time closing high as of last night.

But bond investments have seen huge losses. Consider how broad-based the bond-market massacre has been:

  • Broad measures of the overall bond market have shown definite signs of weakness, with iShares Core U.S. Bond (NYSEMKT: AGG  ) falling more than 3% since the end of April and the actively managed PIMCO Total Return (NYSEMKT: BOND  ) down almost 4% over that time frame.
  • Longer-term-focused bonds have posted even worse results, with iShares 20+ Treasury (NYSEMKT: TLT  ) having fallen more than 8% since late April.
  • Inflation-protected bonds are generally seen providing some defense against rising interest rates, but iShares Barclays TIPS Bond (NYSEMKT: TIP  ) has fallen by more than 7%.
  • Even niche areas of the bond market have seen big losses, with the municipal-bond-focused iShares S&P Municipal Bond (NYSEMKT: MUB  ) down almost 5%, while the emerging-market bond ETF WisdomTree Emerging Markets Local Debt has fallen 10%.

A combination of factors has led to some of these declines, with the strong U.S. dollar hurting international bonds. But the driving force behind all of the drops comes from rising interest rates, and investors need to understand the threat that those rates pose to the future of their bond investments.

Why rates matter
Bond pricing involves fairly complicated math, but some simple examples should show the general impact of rising rates on bond prices. Say you pay $1,000 for a one-year bond that yields 1%, and right after you buy it, interest rates rise to 1.5%. Your bond, which pays only $10 in interest, suddenly looks less attractive than new bonds that will pay $15 in interest over that one-year span. So to make up the $5 difference in expected income, the price of your bond will drop to around $995 -- reflecting the higher rate available on newer bonds.

Longer-term bonds move with more volatility than short-term bonds because longer and more extensive streams of income are involved. As a real example, 10-year bonds that yielded 1.9% just a month ago now sport yields above 2.4%. That half-percentage-point difference means that investors who bought $1,000 bonds at 1.9% will get $5 less in interest not just this year but for all 10 years compared to buyers of new bonds at 2.4%. The price of the 1.9% bond won't drop by a full $50 because you have to discount the value of interest payments far in the future, but the impact is much larger than for short-term bonds. And with maturities extending as long as 30 years, price declines will be severe for the longest-term debt in the market.

Is the worst yet to come?
The scariest part of the bond-market massacre is that we've only seen the slightest of upward movements in rates. As recently as 2010, 10-year bonds were at 4% -- double their recent levels below 2%. Even a reversion in rates just to those typical levels would produce huge losses for bond-fund investors that would make the minor declines we've seen so far look tiny by comparison.

As you assess your portfolio exposure, don't make the mistake of focusing solely on stocks as high-risk investments. As many investors will discover for the first time in their June quarterly statements, bonds might well be the big losers not just now but for some time to come.

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