Then and Now: A Comparison of the 1994 Bond Market Sell-Off and Today’s Market

The recent improvement in the stock market and increase in US Treasuryyields have caused many market commentators to declare that the bull market in bonds is over.  Some have even gone so far as to say that there is the risk of a substantial rise in yields similar to what was experienced in 1994, which caused large losses for bond investors.  In this MIM, we will review what factors led to the rapid rise in yields in 1994, evaluate the similarities and differences with the current market and economic fundamentals, and finally, discuss what measures we can and are taking to protect our clients from a large rise in rates.

One of the biggest risks that a bond investor faces is the risk of inflation.  Inflation erodes the value of future interest and maturity payments bond investors receive, thereby reducing the ability of bond investors to meet their future cash flow needs.  Inflation has historically been highly correlated with economic growth, since growth in spending can cause consumers to bid up the prices of goods and services, leading to price increases.  Thus, bond investors are very sensitive to the threat of future inflation, and any improvements in the economy can cause investors to demand higher yields to compensate for these risks.   The threat of rising inflation was one of the principal reasons the Fed began increasing short-term rates in 1994.  As can be seen in the chart below, economic growth was accelerating during the period leading up to the Fed’s interest rate hike in 1994; compare that with last year, which saw economic growth stagnate at an average annual growth rate of 1.6% over the last four quarters.  This weaker growth and lower inflation rate lessen the risk of an increase in short-term rates.

When we look at time periods of rising interest rates, 1994 is a year that is scorched into many bond investors’ minds.  Interest rates rose dramatically that year, as the Federal Reserve surprised the market with a series of interest rate hikes to slow inflation growth in the US economy.  By the end of 1994, the Fed had increased the Fed Funds rate by 2.5% (250 basis points) and the yields on 2-year, 5-year, and 10-year Treasuries had risen by 347basis points, 262 basis points, and 203 basis points, respectively.  What led to this stunning rise in rates?  In a word:  leverage.  By the end of 1993, the use of derivatives had expanded rapidly, with many investors using newly created financial instruments to increase the yield on their investment portfolios.  When Chairman Greenspan surprised the market with a 25-basis-point rise in the Fed Funds rate in February 1994, many investors suffered losses on long-maturity bonds they had purchased with borrowed funds and were forced to meet margin calls or liquidate their holdings.  Other investors, including the Treasurer of Orange County, California, purchased derivative securities that would pay high yields if interest rates stayed stable or fell.  The rise in interest rates caused massive losses in these leveraged securities, forcing these investors to sell other bonds to cover cash needs.  The selloff and resulting losses ultimately caused Orange County to seek bankruptcy protection.

The question investors should be asking themselves now is two-fold:  What is the likelihood of a surprise increase in interest rates by the Fed? And how leveraged is the bond market to interest rates, or, to put it another way, would a small increase in short-term rates lead to material investment losses in the bond market? To answer the first question, it is helpful to review how the Federal Reserve has adjusted the way it interacts with the outside world.  Prior to 1994, the Fed did not formally state its interest rate target or give any reasons for current monetary policy.  In addition, the Fed did not publish its economic outlook or what factors would cause it to change policy.  In early 1994, the Fed began announcing a target for the Fed Funds rate, but it was not until late 1994 that the Fed added descriptions of the state of the economy and the rationale for the policy actions to its statement.  Since this time, the Fed has taken dramatic steps to increase the transparency of its policies, including holding press conferences, releasing minutes from committee meetings within a month of the meeting, and posting its estimates for future changes in unemployment, GDP, and interest rates.  The result has been much more transparency in the direction and likelihood of future monetary policy changes.  These policy changes have reduced the risk of dramatic price changes in the bond market due to unexpected changes in monetary policy.

To answer the second question, would a small increase in short-term rates lead to large losses in the bond market, it is helpful to understand how leveraged the bond market was to short-term rates in 1994. In the early 90s, many investors poured money into newly created derivatives marketed as a way to increase income in a low interest rate environment, but ignored the risks of how those same securities would perform in a rising rate environment.  Life insurance companies, for example,  purchased large amounts of long-maturity bonds to increase their income.  The “carry trade,” a term for borrowing money with short maturity loans and buying long duration securities, became a popular trading strategy among hedge funds.  These strategies led to magnified losses once interest rates started rising.  Today, the use of derivatives and leverage among banks and insurance companies is closely monitored by regulators in order to quantify how much interest rate risk they are taking, which reduces the risk of a bank or insurance company taking on too much interest rate risk and destabilizing the entire marketplace.  So, while the bond market and the use of debt has grown substantially since 1994, from our standpoint, the market’s leveraged exposure to interest rates has been reduced and is much less of a risk than in 1994.

New Risk in the Bond Market

One risk that is new to the market since 1994 is the increase in the amount of debt securities held by smaller investors.  Market commentators point to these fixed income fund inflows, which have been dramatically higher than pre-2008, as a potential threat to the bond market.  The commentators argue that many of these investors have experienced only positive returns on these funds as interest rates have fallen to all-time lows. A fear has emerged that these individuals will be quick to sell their investments if they were to see the value of their investments fall.  This risk is difficult to quantify, as the reason an individual owns fixed income mutual funds is not always simply for principal appreciation.  Many purchase bond funds and individual bonds to earn a steady income from their portfolio, and would not be deterred by a rise in rates.  Demographically, the large number of baby boomers retiring is providing a boost in demand for low volatility, income-producing assets such as bonds.  While we worry that individual investors could be quick to sell their securities, we are less concerned that these investors have used leverage to increase their holdings of fixed income securities.  The majority of fixed income mutual funds and individual investors do not use large amounts of leverage.  This lack of leverage should reduce the risk of forced selling due to margin calls if rates were to rise.

Based on the analysis above, it would seem that the risk of a dramatic rise in rates caused by leveraged bond investors is fairly small.  This is not to say that we could not see a rise in 10-year Treasury yields of 100 basis points or more if we see a steady improvement in the economy or an increase in domestic inflation.  According to the Fed’s most recent forecast, the unemployment rate is not likely to fall to 6.5% until 2015; the Fed has stated that it needs to see that target unemployment rate before it will raise  short-term rates.  However, this does not mean that investors will wait to sell their bond funds until the unemployment rate falls to6.5%. After all, there are signs the economy is beginning to improve: housing prices are beginning to rise, allowing many homeowners the ability to refinance and improve their cash flow situations, bank lending is on the uptick, and the outlook for corporate profits, while still modest, is improving.  We believe that an increase in interest rates of 50 or 100 basis points is certainly possible, and if that were to happen, it could prove to be an attractive time to take advantage of the higher rates in a still lethargic economy.

How We are Positioning our Clients’ Current Portfolios to Protect Against a Rise in Interest Rates

How do we protect our clients’ existing portfolios against this threat of higher interest rates?  The first way is by limiting the number of long-maturity securities in a portfolio, as the inverse relationship between bond price and yield is amplified the longer the maturity.  Currently, the majority of the portfolios we manage have average durations of four years and below.  These shorter-maturity securities will see much smaller losses if interest rates rise.  A 100-basis-point rise in interest rates on a portfolio with a duration of four years would equate to a loss of less than 3 % this year, and by having a large number of shorter-maturity securities, we will be able to reinvest maturities more quickly into new securities at the new, higher interest rates.  In addition, because we own individual bonds with specific maturity dates, we can select which bonds to sell or hold so the longest maturity portion of a given portfolio can be held to maturity; thus, “losses” do not need to be locked in and realized.

We also protect our client portfolios by limiting the amount and type of callable securities held.  Callable bond values can fall much more than the value of shorter-maturity bonds as interest rates rise and the likelihood of the security being called falls.  When we do purchase bonds with embedded call options, we choose securities with high coupons to reduce the extension risk posed by the possibility of the bond not being called.  Another strategy we employ to protect against rising rates is to invest in floating rate securities, which benefit from a rise in yields by paying higher coupon payments in a rising rate environment.

In summary, the bond market today is very different than it was in 1994.  The Federal Reserve is much more transparent with its policy moves, investors and regulators are much more aware of the risk of rising rates to bond portfolios, and banks and life insurance companies’ leveraging of interest rates is much more tightly controlled than it was in the early 90s. Finally, while the economy is currently showing improvements in key areas, it is a long way from producing strong economic growth.  Gains in areas such as housing, corporate profits, and consumer spending are up against continued deleveraging and reduced spending by many state and local governments.  While we would all like to see the economy grow at the mid-4% rate that led the Fed to hike rates in 1994, we feel it will take us a while longer to get there.  Thus, the risk of dramatically higher rates and a repeat of the 1994 bear market for bonds remains low.