Bond Pain and Perspective on Bank Valuations
Equity investors define a bear market as a 20% or greater reduction in price from the most recent high price. There is no consensus for fixed income. A bond’s maturity and coupon are key variables in determining the sensitivity of price except when overlaying credit and prepayment variables when applicable.
A simple definition might be when the price falls more than three times the annual income for any bond with a maturity greater than five years. If so, it is a low bar when coupons are as low as they are. Definitions aside, the bond market is in a bear market.
The yield on the 10-year U.S. Treasury note (“UST”) was 3.21% on June 27, up from 1.51% as of year-end. Ignoring the impact of the intervening six months for what would be a bond with 9.5 years to maturity, the increase in yield has produced a ~14% loss in value.
The last bond bear market that was brutal occurred in 1994 when the Fed raised the Fed Funds target rate from today’s aspirational rate of 3.0% beginning in February to 6.0% by February 1995. The yield on the 10-year UST rose from 5.19% on October 15, 1993 to a peak of 8.05% on November 7, 1994 once the market could see the last few Fed hikes to come. The 286bps increase in yield pushed the price of the 10-year UST down by 17%, which modestly exceeds the 14% loss this year.
Coupons matter. Fixed income investors entered the current rising rate environment with little coupon to cushion rising yields unlike in the years immediately after the Great Financial Crisis when the Fed first implemented a zero-interest rate policy (“ZIRP”).
Worse, banks entered the current bear market with much bigger securities portfolios given the system was inundated with excess deposits because of actions taken by the Fed and government to offset the COVID-19 recession.
To get a sense of the damage in bank bond portfolios consider Figures 2 and 3 (on the next page) where we have compared the unrealized losses in bank bond portfolios as of March 31 with the unrealized losses as of year-end 1994, which roughly corresponded to the bottom of the 1994 bear market. The data reflects averages.