The Price of Admission in Bonds

By Charlie Bilello

26 Feb 2021

When investors think about investing in bonds, losing money probably isn’t the first thing that comes to mind. Bonds tend to be synonymous with safety, clipping your coupon and allowing you to sleep well at night.

While this is often the case, often is not always. We’re seeing that so far this year with the broad US bond Index down 3%.

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This is a feature, though, not a bug, as risk of short-term loss is the primary reason why bonds have earned a higher rate of return than cash over time.

Risk in bonds primarily comes in two forms: 1) interest rate risk (risk of rising interest rates) and 2) credit risk (risk of default).

For investors in government bonds (Treasuries), the risk resides entirely in the first category as we assume the US government will make good on its promise to pay us back.

For investors in corporate bonds, the risk is often a combination of the two depending on the duration and credit quality of the bonds.

Let’s take a look back at history to gain a better understanding of these risks…

Government Bonds

We’ll start with government bonds, whose risk consists entirely of rising interest rates. As interest rates go up, bond prices go down. And the longer the duration of the bond, the more sensitive it will be to rising interest rates (the more it will go down).1

The relationship is clear in the chart below, which shows the historical drawdowns for various Treasury bond ETFs.

Data as of 2/25/21

No surprise: the longest duration ETF (20+ Year Treasury) has the highest maximum drawdown (26.6%). This occurred back in 2009 when long-term interest rates rose sharply after the recession ended (30-Year Treasury yield moved from 2.5% to over 5%).

Why would anyone want to take the increased risk of investing in longer duration bonds?

They tend to offer higher yields (known as the term premium) and the prospect of higher long-term returns. The last 10 years have compensated investors handsomely for taking on this additional risk, with the longest duration bonds returning 6.9% per year versus 0.5% per year in short-duration Treasury bills.

Will the next 10 years reward long duration investors in the same fashion? Not likely, unless long-term interest rates are on their way to 0. With starting interest rates at a much lower level today (2.24% in 20+ year ETF), a more likely scenario is a lower premium for taking duration risk and lower Treasury bonds returns overall.

Corporate Bonds

Next let’s move to the world of corporate bonds, where you add another element of risk: credit (risk of default).

So you have two components dictating the path of corporate bonds: 1) the direction of interest rates, and 2) the direction of credit spreads.2

There are many different types of corporate bonds (various maturities, credit qualities, and sectors), but we’ll limit our focus in this post to two broad categories: investment grade (rated BBB and above) and high yield (rated below BBB).3

Investment Grade bonds have a duration of roughly 9 years, making them much more sensitive to changes in interest rates than High Yield bonds (duration of 3.5 years).

They also tend to have a much lower risk of default than high yield bonds, making them less likely to incur a significant widening in credit spreads. In turn, they always have a lower yield than high yield bonds, though the spread will vary over time depending on investor risk appetite (the low spread today indicates a high risk appetite).

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Over the past 30 years, the worst drawdowns for Investment Grade bonds have come during recessions, in 2008 (-16.7%) and 2020 (-15.1%). In both of these years, credits spreads widened as investors demanded a higher yield for taking on the additional risk of default. In 2013, you’ll notice another smaller drawdown of around 6.5%, which occurred as interest rates moved sharply higher throughout the year.

High Yield bonds saw their two worst drawdowns in the same recessionary years: 2008 (-35%) and 2020 (-21.5%). The 2013 drawdown is hardly noticeable given High Yield’s lower sensitivity to interest rates.

A picture of credit spreads over time tells much of the story, with the blowout in spreads during 2008 and 2020 being most evident. The maximum spread seen in High Yield during 2008 (21.82%) was multiples higher than Investment Grade (6.56%).

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Where do yields on corporate bonds stand today? Near all-time lows in both High Yield and Investment Grade, making both categories much more susceptible to a rise in interest rates or credit spreads.

Aggregate Bonds

The last category I want to cover is Aggregate Bonds, which are to bonds what the S&P 500 is to stocks.4 This broad category includes a number of different bond sectors with the highest weightings in Treasuries (38.6%), Agency Mortgages (26.8%), and Investment Grade corporate bonds (23.8%).

The result is an instrument that behaves somewhere in between Treasuries and corporate bonds, but much closer to the Treasury end of the spectrum. That makes interest rate risk the primary concern (with a duration of around 6 years), with a lesser impact from credit spreads.

During a brief period in March 2020, we saw both of these factors play out at the same time: a spike in risk-free interest rates combined with widening credit spreads. This led to the largest drawdown in Aggregate Bonds that we’ve seen in recent history (-6.3%).

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But when compared to High Yield bonds and the S&P 500, however, the 2020 drawdown in Aggregate Bonds is barely noticeable.

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Which is another way saying that the risk in equities is many orders of magnitude larger than the risk in aggregate bonds. Looking back at history, stocks have lost more in a bad day than bonds have lost in a bad year.

The current correction in bonds that began last August is now at 3.3% (peak-to-trough). By comparison, the S&P 500 saw a decline larger than that during 14 trading days in 2020 with the worst being a 12% drop on March 16, 2020.

The Price of Admission

If the year ended today, it would be the worst ever for Aggregate Bonds, slightly edging out 1994. Interest rates are rising from historic lows and there is little cushion from the coupon to soften the blow.

For those that equate bonds with safety, this can be a tough pill to swallow. But bearing that risk is the price of admission for long-term bond investors, without which there would be no reward above cash.

1. Duration is a measure of the sensitivity of a bond to a change of interest rates. As a general rule, every 1% increase in interest rates will lead to 1% decline in a bond’s price for every year of duration. For example, a bond with a duration of 5 years will experience a price decline of 5% if interest rates rise 1% (note: the opposite is also true – if interest rates fall 1%, the bond’s price will rise 5%).

2. Credit spreads are the difference in yield between a corporate bond and a risk-free bond of the same maturity. It is a reflection of the additional yield investors require for the additional default risk in a corporate bond. Credit spreads can vary greatly over time depending on economic conditions and investor risk appetite.

3. Throughout this post, our proxy for “Investment Grade Bonds” is the ICE BofA US Corporate Index and our proxy for “High Yield Bonds” is the ICE BofA US High Yield Index. Data Source: FRED.

4. In this post reference to “Aggregate Bonds” refers to the Bloomberg Barclays Aggregate US Index, a widely used benchmark.

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Disclaimer: All information provided is for educational purposes only and does not constitute investment, legal or tax advice, or an offer to buy or sell any security. For our full disclosures, click here.

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