Trump Victory Shocks the Bond Market

Summary:  Investors have been indoctrinated to believe that “stocks are risky, and bonds are safe”.  It is true that bonds have had a lower level of volatility than stocks.  However, bonds have their own set of risks.   We believe that many investors underestimate the riskiness of their bond holdings.  In this article we will highlight how quickly bond prices can change when interest rates change.  We will examine US government bonds and focus on only one risk, interest rate risk.  We  introduce a measure of interest rate risk called “duration”.

What is Duration:  In general, when interest rates move higher, bond prices move lower, and vice versa.  This is what duration measures, the interest rate sensitivity of a bond, or bond Fund.  If you look at the Fund Fact Sheet of a bond fund you will probably see a statistic referred to as “duration”.  Duration is an estimate of the price volatility of the Fund to a 1% change in interest rates.  For example, if a Fund has a duration of 10 and interest rates decrease 1%, the fund will increase in price approximately 10%.  On the other hand, if interest rates increase 1%, the fund will decrease in price approximately 10%.

Trump Victory Provides Fixed Income (mini) Stress Test:  It is often said that markets don’t like surprises.  Given the initial negative reaction of the (equity) futures market, and then the quick reversal as equity indices moved higher, it appears as though the Trump victory was a surprise.

The 5 week period following the election provides us with a mini stress test on bonds.  The yields on US Treasuries made substantial moves higher after Trump’s victory.  The yield on the 10 Year US Treasury on election day was 1.88% and peaked at 2.6% on December 15th, an increase of 0.72%. Here is a chart of the 10 Year Treasury from November 8 through December 15:

 

We thought it would be interesting to look at the total returns on some of the most liquid US government bond ETFs during this time period.  Note that as the “effective duration” increases, so does interest rate sensitivity.  These are the ETFs that we will examine:

Ticker Fund Name Effective Duration
SHY iShares 1-3 YR Treasury 1.881
IEI iShares 3-7 YR Treasury 4.502
IEF iShares 7-10 YR Treasury 7.586
TLT iShares 20+ Treasury 17.33

The following chart shows how key treasury yields changed during this time period:

We can now multiply the change in the relevant interest rate by the effective duration to forecast the estimated loss and compare it to the actual loss:

Ticker Fund Name Effective Duration Estimated Loss Actual Loss Difference
SHY iShares 1-3 YR Treasury 1.881 -0.79% -0.67% -0.12%
IEI iShares 3-7 YR Treasury 4.502 -3.42% -3.00% -0.42%
IEF iShares 7-10 YR Treasury 7.586 -5.46% -5.47% 0.01%
TLT iShares 20+ Treasury 17.33 -10.40% 9.56% -0.84%

In approximately 5 weeks IEF and TLT lost 5.47% and 9.56% respectively, driven by changes is key interest rates of less than 1% (0.76% & 0.72%).  These are pretty substantial losses in a short time period.

Key Takeaway:  The 5 week period following the Presidential election has provided us with a glimpse of how a longer-term rising interest rate environment could affect bond prices .  US government bonds can play a key role in portfolio construction because of their diversifying power and income potential. However, bond prices can change rapidly when interest rates move sharply.  Investors should be aware of the interest rate risk in their portfolios.  A basic understanding of how to interpret the duration statistic can raise awareness.  An example,  the effective duration of TLT is 17.33.  That means that a 1% change in interest rates will cause an estimated 17.33% change in price.  This works in both directions.  A 1% increase (decrease) in interest rates will cause a 17.33% loss (gain) in price.

Taking a Holistic Perspective:  Investors that receive a defined benefit pension that doesn’t increase with inflation have another consideration.  Investors with a defined benefit pension are already exposed to long-term inflation risks and should carefully consider the bond allocation in their investment portfolios.  Nominal bond yields, like the 2.6% 10 YR Treasury Yield mentioned above, are the sum of:

  • The Real interest rate
  • An Inflation risk premium

If sustained inflation drives bond yields higher over time, bond prices will decrease in value at the same time inflation is eroding the value of a defined benefit pension.

Our Approach:  Brave Eagle Wealth Management specializes in building completion portfolios.  We value client defined benefit pensions and carefully analyze the risks.  Client investment portfolios are then used to diversify away from the risks that the pension is exposed to.  The goal is to build a diversified portfolio on a holistic level.

 

 

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