The Risk of a Bond Market Crash

Ever seen a crash in the Tour de France?  The pro cyclist calls it a shit mixer. There is no greater shit mixer in financial markets than when bond markets correct.

Why, because, bond markets are the stable glue that holds commerce together, bonds are debt instruments and debt instruments are secured by assets. What could possibly go wrong?

In the words of veteran US Sports caster Warner Wolfe – “let’s go to the video tape”.

In a time long, long ago the early 1990s bond yields were pushed down by recession, falling inflation and then a jobless recovery. In 1994 however, the cycle turned aggressively after the economic recovery became well entrenched in 1993.

Back then the yield curve was normal, that means at the short end it was a lower rate than at the long end. Back then if the economy was in good shape, long bonds were a higher coupon than short bonds and everyone knew if short bonds were higher than long bonds, there was a recession, right?

In response, then US Federal Reserve Chairman Greenspan raised the Fed Funds rate from 3% to 6% starting in February 1994. In response the Australian yield curve steepened in March of 1994, in 45 minutes the ten year rate went from 6.55% to 7.02%.

It was about midday, mobile phones were near inexistent, but pagers rang out in eateries and bars, at the Brooklyn Hotel in Sydney, eyes went straight to the green Tullett screens over the bar. People jumped from their seats, downed their beers and ran, ran like hell, ran to the dealing rooms, you see, bonds were settles by physical exchange, not via the internet.

All of a sudden the demand of last week’s bonds contracted, and within 45 minutes’ mark to market losses in one fund manager alone tallied $1.36 billion.

After the market closed, blokes that lived in Cronulla, boarded the trains for home, when next they looked up from their paper, they were in Regents Park, they weren’t even on the right train line.

The next morning in an emergency meeting the fixed interest product manager a former pro cyclist asked “the question is, when SHit ARe TRUmps, what is our plan”.

To add insult to injury the equity market got hit late March of 94 and then the RBA raised the cash rate from 4.75% to 7.5% over four months starting in August 1994.

That year Australian bonds generate a loss of -4.7% equity markets lost 8.2%.

What’s the risk of a rerun?

The level of yields and investor exposure to bonds are now more extreme than in 1994. However, a number of factors suggest the risk of a 1994 bond sell-off is still low at present:

  • The US Fed remains unlikely to raise interest rates significantly in the mid-term.
  • European economic conditions remain a mess and Brexit adds to this

In Australia we need to cut rates. Our dollar is too high and while it remains high, imports are too high, exports too low and the trade deficit continues to weigh on the nation’s future.

So as things currently stand, monetary tightening – which was the trigger for the 1994 style bond crash – looks unlikely any time soon and even if official rates rise the impact on lending rates is unlikely to be significant because of the sheer weight of bank notes in the global market.

In addition the yield curve is flat, so the temptation to go long duration is not tempting.

What does this all mean for investors?

While the risk of a 1994 style bond crash in the near term looks low, current bond yields point to subdued bond returns ahead. Trading bonds down the yield curve for gains is difficult.

Prima facie it seems to makes sense for investors requiring investment income to search out alternatives offering higher yields short duration corporate debt, real estate investment trusts and high yield shares given that these assets offer some protection as they benefit from stronger economic growth and as such can probably all better withstand a gradual rise in bond yields.

Very low bond yields highlight the need for active fixed income management where the portfolio manager can increase the exposure to less vulnerable credit and reduce a portfolio’s duration to limit the impact of a rise in bond yields.

The ghosts of 1994 are never far away from anything we do in asset allocation and portfolio construction, we know when we make great investment calls, it’s the clients idea and when we make bad calls its ours.

So how do the fixed interest portfolios operate within the context of what we have laid out above?