Over the past 40 years, bond yields have largely moved in one direction: down. The 10-Year Treasury went from a yield of 15.84% in 1981 to an all-time closing low of 0.52% in 2020.
This has been a blessing for bond investors as prices move inversely to yields. And over the last 2 years, as yields plummeted to historic lows, bond investors have experienced extraordinary gains.
But that was the past. What has served as a tailwind for decades (falling rates) is now a major headwind. For there is simply no escaping bond math in which lower yields portend lower future returns.
And with a 10-year treasury yield of 0.92% to start the year, it wouldn’t take much of an increase to make this the worst year for bonds in history (-2.9% in 1994).
We’re on pace for that right now as the 10-year yield has moved up to 1.30% and US bonds are down 1.6% year-to-date.
With a duration of roughly 6 years, a 100 bps (1%) increase in yields would lead to a decline of 6% in aggregate bond prices.
The longer the duration, the larger the decline in yields. We have seen this play out in the long-term zero coupon bond ETF ($ZROZ) which is down over 23% from its high last March (its duration: 27 years).
What could cause bond yields to continue to rise from here?
1) Rising Inflation.
Inflation expectations in the US are now at their highest levels since 2012. Interest rates tend to be highly correlated with rates of inflation.
2) Rising Supply.
US National Debt has increased over $4.6 trillion (20%) in the last year to nearly $28 trillion. It is expected to spike higher once again with the passage of a $900 billion stimulus bill in late December and another $1.9 trillion bill likely coming in the next month. More stimulus means more debt and more bond issuance. This increase in supply could put upward pressure on rates.
3) Rising Growth Rates.
As the end of covid-19 is now in sight, economic growth rates are expected to continue to recover. Historically, there has been a high correlation between nominal GDP and interest rates.
Collectively, these factors point to the potential for a continued increase in interest rates and what could very well become the worst year in history for bonds.
To sign up for our free newsletter, click here.
Disclaimer: All information provided is for educational purposes only and does not constitute investment, legal or tax advice, or an offer to buy or sell any security. For our full disclosures, click here.