Higher Interest Rates means Bonds and Leverage Don’t Mix

Stocks are stories, bonds are mathematics.

When buying a stock, investors will have large swings in the value of their holdings on any news that causes a reassessment in the future prospects of this company. With bonds, if there’s no bankruptcy investors know exactly what they’re getting the day they make the investment until maturity.

The volatility in the bond prices before maturity is determined by two factors: any significant change in the credit risk, and changes in interest rates. The first factor can be mitigated by diversifying a portfolio of bonds. The second factor cannot be mitigated, and has a far bigger impact on the value of bonds.

The price of a bond is inversely correlated to interest rates. The more interest rates move up, the more bond prices will fall. For example, in the summer of 2016 you could have bought a Temasek bond maturing in 2042 (26 year maturity) yielding you 2.83% p.a. Since Temasek is seen as an ‘AAA’ rated issuer, it is close to risk free. All bonds are priced off the loan interest rate (SIBOR in Singapore), which was 0.60% p.a. at the point of purchase.

Fast forward almost two years later, and SIBOR has more than doubled to 1.39% p.a. now. The Temasek bond is still considered close to risk free so nothing has changed in the credit risk, but the bond has fallen -15% in price. Net of the 5.6% interest received for the holding period, investors still have a net loss of almost -10%.

These losses have been experienced in every bond, with longer maturities experiencing steeper losses. With this market environment in mind, it is surprising that bond portfolios with leverage are still being recommended. Per our example, the situation is risky enough on standalone bonds. When adding bank borrowing to buy even more bonds, investors get squeezed on both sides when interest rates go up, causing double the amount of losses.

Zooming out to the big picture, we have just had three decades of falling interest rates, culminating in the last 10 years of zero (and in some countries negative) rates. At the craziest point in the bond market bubble investors were paying interest (i.e. the bonds had a negative yield to maturity) to buy ten-year bonds of German and Swiss governments.

Most investment advisors have no first-hand experience in what an inflationary environment looks like, so we either have to seek the counsel of older and wiser investors, or study financial history. In doing so we can see that in the USA in the 1970s:

Cash interest rates went as high as 18% p.a.
A decade prior to this rates were at 2% p.a.
The safest of AAA rated long dated bonds lost more than -50% of their value during the decade, equal to the losses suffered by equity markets
Bonds and equities became highly correlated, providing no diversification benefits

Cash interest rates went as high as 18% p.a.
A decade prior to this rates were at 2% p.a.
The safest of AAA rated long dated bonds lost more than -50% of their value during the decade, equal to the losses suffered by equity markets
Bonds and equities became highly correlated, providing no diversification benefits

The rest of the world experienced similar movements in rates and bond prices. The move in bond prices over the last 35 years is the longest recorded bull market in any asset class. Like all bull markets, the signs of a major top are all in place, from negative interest rates, to countries like Argentina taking advantage of this bullishness to issue a 100 year maturity bond in 2017. Less than a year later, Argentina has already gone to the IMF seeking a bailout, and we don’t even have a crisis environment yet.

Even if the magnitude of the move in interest rates in the 1970s is not likely to be repeated, it is clear that interest rates are on the way up. Historically central banks have continued to tighten until the economy has started to slow down. This time will not be different.

Bonds still have a role to play in a diversified portfolio, but it is imperative to take into account the bigger picture on interest rates by keeping maturities shorter. The math of bond returns is clear in that long-dated bonds are already underperforming cash, and are likely to continue to do so for the whole of the next decade. This means that even the most thrill-seeking of investors should avoid leveraging bond portfolios.

By LEONARDO DRAGO

Co-founder of AL Wealth Partners, an independent Singapore-based company providing investment and fund management services to endowments and family offices, and wealth-advisory services to accredited individual investors.