Potential for Unprecedented Losses in Bonds

By James Saft

A bond market facing unprecedented circumstances poses significant risks for investors, potentially leading to historic losses.

This situation is particularly alarming not only because a 10 percent loss in global sovereign debt values is within the realm of possibility, but also because bonds are typically viewed as a stabilizing asset class. It’s akin to having your house destroyed by faulty wiring in a smoke detector.

Moreover, it is concerning that it is challenging to envision a scenario where bonds might decline sharply while other financial assets perform well.

A recent study by Fitch Ratings indicated that if the yields on global sovereign bonds were to return to their levels from 2011, investors could experience losses of up to $3.8 trillion, which is slightly over 10 percent of the $37.7 trillion in outstanding debt from the top 50 investment-grade issuers.

Fitch noted, “As rates hit record lows, investors face growing interest-rate risk. A hypothetical rapid rate-rise scenario illuminates the potential market risk faced by investors holding high-quality sovereign bonds.”

Currently, median yields on 10-year notes are 270 basis points lower than they were in July 2011, while one-year securities have seen a decline of 176 basis points. Losses would differ based on the extent of interest rate drops; for instance, bonds from eurozone countries like Spain and Italy could lose 21 percent of their value.

However, this does not imply that a quick return to the interest-rate environment of even five years prior is likely. In fact, policymakers and investors are mainly focused on combating inflation and preventing further declines in yields.

A 10 percent dip in global bond portfolios would mark the most significant downturn in the last three decades. Since 1986, the steepest loss recorded by government bond investors occurred in 1994, when they lost just 3.1 percent, with slight negative returns also noted in 1999 and 2013.

Notably, investors often maintain a home bias in their bond portfolios, so a global overview might not accurately reflect how these losses will unfold. The most significant drawdown in recent history for U.S. Treasuries occurred in 1980 when 10-year notes lost 16 percent of their value amid the Federal Reserve’s aggressive campaign against inflation. For long-dated U.S. Treasuries, the worst year was 1931, recording a 9 percent loss.

Examining historical trends may be of limited utility, especially since global interest rates are at historically low levels, meaning we have never before encountered this specific scenario. Over $10 trillion in global debt currently carries negative yields, which means investors are effectively paying to hold these assets.

This situation implies that a typical portfolio of government debt is not generating the kind of income seen during past downturns. For example, at the start of 1980—the worst year for 10-year U.S. notes—yields stood at 10.8 percent, whereas today, 10-year notes yield just 1.54 percent.

As Anthony Doyle of M&G pointed out in a 2015 report, “The reason total returns have rarely been negative is that investors were receiving relatively high coupons, offering a buffer against capital downturns. Nowadays, total returns in government bond markets will largely result from movements in capital, with income providing little support during a bear market.”

One potential outcome is that if there were a sell-off in global bonds, the usual support they’ve relied upon in the past may be diminished. Some investors might be less willing to hold bonds to maturity, which would offer meager income in exchange for a declining asset value.

Again, it’s essential to note that the discussion here is about returning to the status quo of 2011—far from representing a "normal" year in the context of interest rates.

Investors may find the prospect of a recovery in growth and inflation, whenever it occurs, even more unappealing than the present stagnation.