Halloween: The scariest year for bonds in memory

The US Aggregate bond index is heading for a loss of close to 15 per cent this year, which would make 2022 the worst calendar year for bond investors since the founding of the republic. As markets reach Halloween, portfolios built over four decades of gently falling inflation are nursing historic losses. Pension funds, endowments and wealth managers who treated high-grade government debt as a safe store of capital have had a nasty shock. Duration, once a reassuring measure of steady income, has become a machine for destroying value.

The scale is easier to grasp against history. The aggregate index was launched in the 1970s, and its previous worst year was 1994, when a surprise run of Federal Reserve rate rises cost holders less than 3 per cent. This year's loss is several times that, and it has come with two months still to run.

Models built for calm

The intellectual mistake was to rely on normal distributions in risk software. For forty years quantitative risk systems assumed that bond volatility stayed within well-behaved Gaussian limits, with fat tails showing up only in sudden rallies into safe assets. A violent bear steepening across the world's government bond curves at once, with short and long yields both rising by hundreds of basis points within three quarters, was treated as a five-standard-deviation impossibility. The bond market has now corrected that complacency.

The error was partly one of sample. Value-at-risk models are usually calibrated on a few years of recent data, and the recent data came from an era in which central banks bought bonds whenever markets wobbled. A model trained on quantitative easing learns that yields fall in a crisis. It has nothing to say about a year in which the central bank is the source of the shock, because it has never seen one.

Low coupons, big losses

Duration risk is lopsided. When yields sit near 1 per cent, the price of a long-dated bond is as sensitive as it can be to each small rise in rates. A thirty-year bond with a 1.5 per cent coupon loses nearly a third of its value when market yields rise by two hundred basis points. Fund managers held hundreds of billions of dollars of low-coupon government debt issued during the pandemic, so the speed of the Federal Reserve's tightening destroyed an extraordinary amount of market value.

The coupon matters because it is the only cushion a bondholder has. A bond paying 1.5 per cent a year offsets a price fall of only 1.5 per cent before the holder is behind, which at long maturities is wiped out by a rise in yields of well under ten basis points. The ten-year Treasury yield began the year near 1.5 per cent and has spent much of October above 4 per cent, a move large enough to overwhelm any income earned along the way.

Collateral that shrinks

The losses did not stay in the accounts. As bond prices fell, secured borrowing began to unravel. In the repo market, lenders who had advanced cash against par values found their collateral worth fifteen to twenty per cent less than when it was pledged. Margin requirements went up, leveraged bond funds had to sell securities to cut their borrowing, and the selling pushed prices down further in a classic fat-tail feedback loop.

Britain supplied the clearest example last month. Pension schemes that used liability-driven investment strategies had hedged their obligations with leveraged positions in long-dated gilts. When gilt yields jumped after the government's fiscal statement on 23 September, the schemes faced collateral calls they could meet only by selling gilts, and the Bank of England had to step in as buyer to stop the spiral. The trigger was local, but the machinery was the same that runs through leveraged bond portfolios everywhere.

No shelter in balanced funds

The worst part of 2022 has been bonds falling alongside shares. The standard 60/40 balanced portfolio assumes that stocks and bonds move in opposite directions. When growth cools and profits fall, lower interest rates produce gains on bonds that steady the overall fund. In an inflation shock that relationship flips, and the two move together.

Share valuations and bond prices are both discounted at the same risk-free rate. As that rate soared, both fell together and investors had nowhere to hide. Balanced portfolios have suffered peak-to-trough losses comparable to those of the 2008 financial crisis, without the bond rally that cushioned investors then. Trustees are finding that the old asset-allocation manual was written for an age of falling inflation that has passed.

The negative correlation that made the 60/40 portfolio work is historically young. Through the inflationary 1970s and much of the 1980s and 1990s, stocks and bonds tended to rise and fall together, because both were driven by the same swings in inflation expectations. The helpful inverse relationship became dependable only around the turn of the century, once inflation was low enough that growth scares, not price scares, dominated markets.

The case for owning bonds now

The strongest argument against despair is arithmetic. Higher yields mean higher future income, and a ten-year note yielding above 4 per cent can absorb a far larger rise in rates before its holder loses money over a year than one yielding 1.5 per cent could. For a buyer today, much of the damage has already been done to someone else.

That argument is sound for new money, but it does little for the pension fund that bought at the bottom of the yield cycle and must now mark its holdings to market. Nor does it restore the diversifying role of bonds while inflation remains the main driver of both asset classes. The Federal Reserve's decision on 2 November, and the October inflation figures due later that month, will show whether that driver is fading.

The bond losses of 2022 will change how institutions manage risk for good. A safe asset that loses more than fifteen per cent in a year forces trustees to hold more cash and less leveraged duration, and balanced funds will probably spend years rebuilding around that lesson. Halloween will pass, but stocks and bonds falling in step will haunt institutional balance sheets for the rest of the decade, and the first visible sign will be trustees cutting leverage in their liability hedges well before they add back long bonds.