The Bond Market Massacre Began on This Day

Stocks recorded their worst day of the year, as the S&P 500 (INDEX: ^GSPC) and the narrower, price-weighted Dow (INDEX: ^DJI) were down 1.2% and 0.9%, respectively. Predictably, the VIX Index (INDEX: ^VIX) shot up 14%, to close at 14.67 (the VIX, Wall Street's "fear gauge," is calculated from S&P 500 option prices and reflects investor expectations for stock market volatility over the coming 30 days).

Another lesson from the mid-'90s
Last Friday, this column walked down memory lane to 1996 to illustrate why higher unemployment is good for stock prices. Today, our destination is 1994, for a lesson on the risks of owning bonds in a zero interest rate environment (i.e., when policy rates can only go up). Indeed, 19 years ago today, on Feb. 4, 1994, the Federal Reserve unexpectedly raised the federal funds rate by 25 basis points -- the first increase in five years (Note: One basis point is equal to 100th of a percentage point.) That month, long-term Treasury bonds -- those with the greatest sensitivity to rising rates -- lost 4.5%.

Before the year was out, the Fed had raised rates six more times, for a total increase of 2.5 percentage points. Fortune called it a "bond market massacre," estimating U.S. bond market losses through the third quarter at $600 billion (that was real money back then). Investors weren't even able to rely on their stock holdings to make up for these losses -- the total real return on the S&P 500 in 1994 was negative 1.1%.

Losses are not atypical under such circumstances: Fund manager Vanguard has calculated that, between 1973 and 2010, the average 12-month real return on a 60% stocks/ 40% bonds portfolio during periods in which interest rates increased by at least 200 basis points is negative.

Last Friday's surprise pushed forward into the future any interest rate hike by the Fed. That prospect is not imminent. However, as the events of 1994 prove, the Fed can surprise; furthermore, it only has partial control over long rates. Once rates start to go up, most investors won't be able to reposition themselves fast enough. Investors need to be nimble beforehand.

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