How Investors Can Prepare for a Bond Bear Market

Most fixed-income investors are not prepared for a bond bear market and the implications of rising interest rates. Who can blame them? They’ve enjoyed one of the longest bull runs in the history of the bond market. Many of them weren’t old enough to even consider owning bonds when the previous bull market began in 1981 and those that were have grown accustomed to consistently rising bond prices over the past 35 years. But that is about to change. This article will provide insight for fixed-income investors on how to survive and thrive in a rising interest rate environment. (For related reading, see: Taking the Bite out of a Bear Market.)

The New York Times reported on May 8, 1981, that the U.S. Treasury auctioned $2 billion of new 13.88% 30-year bonds at an average yield of 13.99%. In the article, Michael Quint mentioned that the Treasury also auctioned 10-year bonds at 15.38% for an average yield of 15.32%. This auction was held at the end of an unprecedented rise in interest rates and represented historical highs for interest rates. Thirty-five years later the 30-year Treasury bottomed at 2.09% on July 11, 2016, and a few days prior the 10-year Treasury hit an all-time low of 1.34%. Keep in mind that bond prices rise when yields fall and vice-versa. (For related reading, see: Understanding Bond Prices and Yields.)

Inflation and Interest Rates

Knowing how markets react to these changes can help prepare bond investors for the market ahead. For example, the cause of rampant inflation and rising interest rates during the 1970s was multiple missteps by the Federal Reserve and central government. Google Bretton Woods and Arthur Burns to learn more. Today a run-up in inflation and interest rates could be caused by unprecedented fiscal stimulus from the past eight years that for the most part was never introduced into the economy due to stiff regulation and a lack of urgency due to low interest rates and no clear indication they would rise. There was simply no reason for capital expenditures by corporations if money could be borrowed at the same rates well into the future.

A Trump presidency could very well lead to significantly higher interest rates if he is able to eliminate regulations and put an additional $1 trillion into infrastructure. Should he begin introducing value-added taxes (VATs) on imported goods, he could very well set in motion a global trade war. This of course is inflationary by nature, and to slow inflation the Federal Reserve would likely raise its key borrowing rate faster than anticipated. Current Fed Chair Janet Yellen is considered to be dovish by nature and there is the possibility she would not get out in front of inflation quick enough. (For related reading, see: Can Infrastructure Really Stimulate the Economy?)

Flexibility Is Key for Bond Investors

Bond investors need to be more flexible in a rising interest rate environment. They need to be aware that some bond ETFs perform well during domestic rising rates based on the nature of the underlying bonds as well as the direction of the dollar and the acceleration of inflation. For instance, a period of rapidly rising interest rates in the U.S. coupled with a declining dollar may produce positive returns for non-currency hedged emerging market and sovereign debt ETFs. This could occur during periods when the dollar is sliding faster than interest rates are rising within the countries that make up the bond portfolio. Also, U.S. high-yield bonds can rise in value during periods of rising interest rates, coupled with a strong equity market. Treasury inflation protected securities (TIPS) have the ability to perform well during periods when interest rates are rising slower than the growth of inflation.

The key to successfully navigating a fixed-income bond bear market is to carefully analyze the direction of the U.S. dollar and monitor the rate of inflation and the equity markets as indicators for which bonds might outperform. Easier said than done, but those investors that have this unique expertise will have the ability to not only survive the coming bond bear market but they will thrive. (For related reading, see: Tactical Tips for Bond Investors.)