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Bonds: From Risk-Free Returns to Return-Free Risk?

When looking to add a low-risk compo­nent to an investment strategy, investors typ­ically think of bonds. These fixed income in­struments have deliv­ered an outstanding and very reliable per­formance over the last 40 years, thanks to the continuous trend of falling interest rates, and to this day, they are commonly perceived as a safe investment. However, a lot has changed over the last year and many core assumptions have been overturned. In the aftermath of the covid crisis, the climbing inflation expectations, the unprecedented stimulus operations and the record levels of public debt, does the investment case for bonds still stand?

Interest rates at a turning point

Bond prices are inversely related to interest rates, meaning they fall when interest rates rise, and vice versa. When interest rates fall, newly issued bonds will have a lower interest rate compared to those issued in the past, which increases the demand for the existing bonds and pushes prices higher. This is precisely the scenario we have experienced over the past 40 years in the U.S. and the main reason why bonds came to be viewed as low-risk, reliable invest­ments.

Figure 1: Development of US effective Federal Funds rate, 1980 – 2021

Source: Federal Reserve of St. Louis

There is, however, another scenario too: Rising rates. When interest rates rise, investors flock to the newly issued bonds, that offer better rates, causing the older bonds to lose value. This might seem obvious, but the important thing to note here is that this loss in value can occur very quickly and it can be quite substantial, as illustrated in Figure 2. For instance, a mere 2% increase in the interest rate leads, on average, to a loss in value of almost 10% for a 5-year bond. In the case of a 30-year bond, almost half of its value is wiped out, due to that seemingly small interest rate increase.

Overall, the ultimate impact of an interest rate increase on a bond depends on the magnitude, the speed and the persistence of that increase. If it’s only a small change that is perceived as exceptional and likely to be short-lived, many investors hold on to their bonds, thereby limiting the losses. Contrari­wise, in the case of a rapid and substantial interest rate increase that is expected to persist, bondhold­ers rush to sell their positions and the price decline of bonds is much more severe, in particular for bonds with a long maturity (see Figure 2). If these bonds also serve as collateral for a loan, such an increase can lead to margin calls and forced sell-offs. The risk of a banking crisis related to the huge derivatives market, where most instruments are tied to interest rates, is even larger.

Figure 2: Impact of interest rate increases on bond value

Source: Kopernik (2020), Bloomberg data

For some, this might seem like a far-fetched scenario, given the fact that for the last 40 years, we have seen interest rates more or less continuously decline. Es­pecially over the last decade, consistent and massive interventions by the Federal Reserve successfully kept interest rates extremely low, even during turbu­lent periods and even when it was thought that an increase was inevitable. The central bank’s resolute stance and its firm commitment to its interest rate policy bolstered investor confidence throughout the covid crisis as well and it created the impression that interest rates could be kept low forever.

And yet, we feel that the extraordinary develop­ments we saw over the past year and the inflationary pressures that built up are too powerful to ignore. We have very likely reached a crucial turning point and the era of ultra-low interest rates may be about to come to a close.

Among the clearest indications that we are likely headed in that direction are the unprecedented debt levels and the almost exponential increase in the money supply. Of course, public debt in the U.S. has been climbing over the past 40 years (see Figure 3).

Figure 3: US public debt as a percentage of GDP, 2000-2020

Source: Federal Reserve of St. Louis

It is therefore far from a new problem, however, what is different this time, is its record acceleration. In addition, the covid crisis saw the Fed balance sheet being inflated even more in an effort to stim­ulate the economy and avoid a recession, but with interest rates at a record low, monetary stimulus is no longer an effective instrument, creating an even higher demand for fiscal support. The combi­nation of massive monetary and fiscal stimulus has created enormous liquidity flooding the markets, an inflationary force which can, at some point, only be dampened by higher interest rates.

Another important factor that is set to contribute to higher interest rates is the deglobalization trend. Since the 90s, we have witnessed the emergence and establishment of international value chains and increased trade across the globe, that pushed pro­duction prices down and created seemingly endless supply capacities. Thanks to these disinflationary forces, the Fed was relieved of the burden of having to increase interest rates, something it usually does when it wants to avoid an overheating of the economy. However, we are now seeing signs of this trend slowing down, or arguably even reversing. The ongoing impact of the pandemic on global supply chains and the U.S.-China trade tensions are just two among many deglobalizing forces. Should this trend continue or intensify further, it could put pressure on the U.S. central bank to proceed with interest rate hikes in order to keep inflation in check.

Given the scale and the importance of these shifts in the global economic landscape, we believe that the risks of climbing inflation and higher interest rates should be taken seriously by investors and especial­ly by bondholders. Clearly, we don’t expect this sea change to happen overnight. After four decades of declining interest rates, such a reversal will take time and will be accompanied by significant volatility, but even so, this outlook considerably weakens the in­vestment case for bonds and presents a very unat­tractive risk-return ratio.

What about TIPS and floaters?