In previous week we witnessed the U.S. 10-year Bond Yield surpassing the 5% threshold, although it concluded the week below this level.
This is significant because the long-term bond yields have been rising relentlessly and causing bond prices to fall, due to their inverse relationship.
Examining the 20-year and 30-year U.S. bonds, their yields stood at 5.289% and 5.078%, respectively, by week’s end. To provide context, just six months ago, these yields were slightly below 4%.
You might think that the change wasn’t big, but it had a big impact to bond prices. For instance, the iShares 20 Plus Year Treasury Bond ETF (TLT), comprising such U.S. long-term bonds (20 years and beyond), has witnessed a 21% drop in price over the last half-year, corresponding to a rise in bond yields exceeding 1%.
Investors may argue that interest rate hikes have similarly caused declines in stock, cryptocurrency, and private equity valuations, but these assets are known to be volatile. Try explaining to a bond investor when he has experienced a double-digit percentage loss in bond investments within a single year.
An investor holding TLT for the past decade would have incurred losses. A decade might be deemed a sufficiently long investment horizon, and an investment in a ‘safe’ bond asset should ostensibly shield against downside risks, even if returns are not remarkable. Yet, the reality reveals that losses were still incurred even after a decade within a supposedly secure investment.
For a long time, bond investors were reassured that bonds were safe investments, and they often lacked psychological preparedness to endure substantial declines, particularly as bond prices are currently plummeting. For holders of short-term bonds or treasury bills, they can simply hold these instruments until maturity to recover their initial capital, with the only loss being opportunity costs.
However, for those who invested in bond funds, there is no fixed maturity date, and retirees who need to liquidate these holdings within a couple of years are particularly vulnerable. This scenario results in a dent to their retirement funds, as they confront a double blow where both stock and bond prices are simultaneously in decline. This is known as the sequence of return risk, and they bear the full brunt of it. Mitigating this impact is possible through income laddering or by reducing or delaying withdrawals.
On the other hand, some investors now find long-term bonds appealing. If the Federal Reserve does indeed cut interest rates next year, bond prices would experience an upswing, and longer-duration bonds would benefit more. Even in the case of delayed rate cuts, some find the bond yields of over 5% an attractive proposition.
Nonetheless, it’s improbable that interest rates will approach zero again, given the prevailing geopolitical tensions that impact supply chains and trade, rendering the past era of cheap Chinese imports unsustainable. Increased trade restrictions and conflicts disrupt commodity supplies and elevate prices, making ultra-loose monetary policy unlikely in the near future as inflation may prove to be stubborn.
Even if long-term bond prices do rise, they are unlikely to regain their previous peaks. The effective duration of TLT currently stands at 16.1 years, implying that a 1% rate cut would result in a 16.1% increase in TLT’s price.
The futures markets are predicting a 0.5% cut next year, potentially translating to less than 10% gain for TLT. Personally, I am of the opinion that the potential gain is limited, while the risk of higher yields has yet to subside fully, suggesting that TLT may face further declines before rebounding.
