A few years ago Vanguard performed a study to see how the Barclays Aggregate Bond Index would be affected by an overnight 3% rise in interest rates (something that has never actually occurred). They calculated what would happen if rates suddenly rose from 2.1% to 5.1% and showed the impact going out 5 years:
You can see the immediate loss would be around 13% (they also noted that the worst 12 month loss ever in bonds was -13.9% in 1974). But because the yield on bonds would now be much higher, the expected return going forward would now be around 5.1% annually, meaning the breakeven would be just over 3 years. So not exactly a crash of epic proportions.
So what are inflation-linked bonds? They are most typically debts issued by sovereign nations whose nominal interest rate is adjusted, either up or down, by an inflation measure.Despite the obvious allure of this kind of debt — it eliminates a risk: inflation, duh! — there are not many issuers worldwide. Total global issuance is $3 trillion. The United States, with $1.2 trillion, and the United Kingdom, at about $800 billion, are the principal movers, though there is growing issuance in France, Italy, Spain, Germany, and Brazil, among other markets.
|Asset Class||Index||Performance YTD 2016|
|Emerging Markets||MSCI EM||13.8%|
|REITs||NAREIT Equity REIT Index||13.13%|
|High Yield Bonds||Barclays Global HY Index||14.49%|
|US Bonds||Barclays Aggregate||5.8%|
|US Large Cap||S&P 500||7.84%|
|Commodities||Bloombery Commodity Index||8.63%|
|Developed Intl. Markets||MSCI EAFE||-.85%|
|US Small Cap||Russell 2000||11.46%|
Do bond holders that have a negative yield pay the issuer?
Now let’s look at an example with negative yields. If you buy the same bond at $101, and it matures a year later at $100, then your yield is -1%. You paid more for the bond than you received back when the bond matured, and you didn’t receive any coupon payments along the way. And this same mechanic can work for a bond that pays coupons. Say there is another bond that pays a $1 coupon in one year, along with the $100 you get back in maturity proceeds, in total you get $101. If you pay $102 for that bond today, then in a year you have again earned a yield of around -1%. You paid $102 in return for total cash flows of ($100+$1) = $101.
Inflation levels are low and expected to remain low—but that’s no excuse for not protecting against unexpected moves, according to Meketa Investment Group.The Boston-based consultant advocated for allocations to inflation-protected bonds and real assets to safeguard portfolios against sudden inflation spikes.“Holding assets that do not decline in real value during unexpected inflationary periods enhances the ability of the total portfolio to make payouts while protecting its value on the downside,” the authors wrote. “This diversification reduces the volatility of the total portfolio’s value, even though the inflation-hedging assets may demonstrate considerable volatility when viewed in isolation.”
Edward Altman says the benign credit cycle is in “extra innings,” but the metaphorical relief pitchers — central bankers — are running out of gas.
Bond yields in the U.S. hit all-time lows this week. Is the U.S going to be the next country to enter the negative rate club?