Bad times for bonds lately, for sure. The extent (-12.3% for BND since November) is certainly not nothing, but has produced howls and hyperbole far outstripping what would accompany a similar loss for equities. Why do bond losses produce such outsized panic?
Interest rate hikes, inflation fears, shifting market sentiment, supply chain constraints, lockdown in China, the invasion of Ukraine, and on and on have combined to influence a significant decline in bond prices over the past six months. I have seen this in my test portfolios (check out the Qian portfolio) and in my personal portfolio, which is slanted towards the most volatile bonds of all, Long-term and extended duration Treasuries. My favorite podcasts have also highlighted what’s been up (or down) with bonds lately: episode 173 of Risk Parity Radio, and 199 of Rational Reminder.
You may have seen this chart floating around Twitter from Jim Bianco showing just how bad it has been. Yes, that bold line shows the worst start for bonds over the five decade history of the Bloomberg bond index, and given this start, it makes you wonder how bad things could look by the end of December.
But even more dramatic than the fall in bond prices has been the reaction to it. Bianco seems to pop up everywhere with his messages of “bond market carnage” foretelling a supposed paradigm shift for markets and finance. Stocks are down too, but there the message is that this is what happens, and a 15% decline in the S&P is actually normal. Yes, tech stocks are down a lot, but everyone knew their prices before were crazy anyway, so yeah, no biggie. Buy the dip, this is where the money is made... all the usual cliches.
So that got me thinking - why is there such asymmetry with how investors respond to bond declines as opposed to stock declines? And what might that mean for Risk Parity investors?
My theory: people freak out because most people invest in bonds only as a “safe” asset, so when that asset appears not so safe after all, they feel something like betrayal. Imagine the native Californian who is deathly afraid of earthquakes, so they move out to Kansas, the last place they’d ever expect an earthquake. Of course, if an earthquake struck there, too, the unease would be especially acute. Investors expected bonds to be the thing they could count on, the succor in their times of turmoil, and have now been thrown into disarray.
What to make of all of this from a Risk Parity perspective? It certainly is unusual, and does fly in the face of one of the bedrock “truisms” of Risk Parity, that of negative correlation between stocks and long-term Treasuries. On closer inspection, though, the exception to the rule is that in times of high, rising, and unexpected inflation, that relationship doesn’t hold and both can go down together. For those times, commodities and gold can help stabilize a portfolio, and in this respect, both are performing as advertised (commodities especially, and gold somewhat).
So, the decline in bond prices is steep, and the fact that it is happening as equities decline is unusual, but I don’t think it's worth panicking about. First off, we should treat it the way we would treat a drop in stock prices - a chance to buy more. My favorite bond fund, Vanguard's Extended Duration Treasuries, is trading under $100 now, so I'll be stocking up. Second, is it even really that bad? The chart below shows the yields (so, prices would be the inverse, more or less) for 10-year Treasuries over sixty years - are we really going to freak out about the tiny blip at the far right?
To get a full sense of the panic, here is an interview with Bianco: