Can the Bond Market Crash?

Six Reasons Why a Crash Simply Isn't in the Cards

Broken pennies
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When it comes to the bond market, one of the most talked-about issues right now is whether the U.S. Federal Reserve’s need to raise short-term interest rates will bring about a bear market. This topic is frequently discussed in dramatic terms, which fosters the belief that the bond market is on track for a crash.

There’s one problem with this line of thinking, however: it just doesn’t make any sense.

In reality, the bond market’s reaction to the prospect of Fed rate hikes is likely to be gradual. Instead of a sudden, dramatic crash, bonds are likely to suffer modest price pressure over an extended period. This should result in both higher volatility and an extended period of lower returns, but the odds of an outright crash are minimal.

There are no fewer than six key reasons why this is the case:

Bond Market Crashes Are Rare to Non-existent

A look back through the return history of investment-grade bonds shows a track record of stability in the past 30-plus years. The closest thing to a crash occurred in 1994 when the Fed mismanaged policy by raising rates too quickly, but even then the loss was only 2.9%.

Skeptics will note that the trailing 30-year period largely incorporates a bond bull market, and that’s true. So what does a bear market look like? Investors may recall that the late 1970s were a period marked by soaring inflation – the worst possible condition for the bond market.

Bonds responded unfavorably, but even in this case, the losses were modest. According to the database kept by Aswath Damodaran of NYU’s Stern School of Business, the 10-year U.S. Treasury note produced the following total returns from in each calendar year from 1977 through 1980: 1.29%, -.0.78%, 0.67%, and -2.99%.

Granted, yields were higher then – meaning that there was a larger yield cushion to offset price declines. Still, the numbers show that no crash occurred even in the unfavorable conditions of the late 70s – and investors more than made up for this period of weakness with the strong returns that occurred in the subsequent years.

Fed Rate Hikes Are a Known Issue

This is probably the most important reason why a bond market crash is extremely unlikely. Typically, markets only exhibit violent reactions to surprising developments and not to issues that are well known in advance.

When it comes to Fed rate hikes, the latter is the case. Since 2013, the markets have known that the most likely scenario was that the Fed would start hiking rates in mid-2015. This has left investors with plenty of time to prepare, and it removes the element of surprise from the equation. While the timing of the first hike remains a key factor for the markets, don’t expect a major downturn in the weeks leading up to the Fed’s announcement that it is boosting rates, or even on the day of the of the announcement itself. The markets simply don’t respond that way to events that are anticipated this far in advance.

The Market Is Already Reacting to the Shift in Fed Policy

The expectation that the Fed will raise rates is already reflected in market prices.

Even as longer-term bonds have performed very well the past few years, the yield on the two-year U.S. Treasury note has risen (a phenomenon discussed here).

Since the two-year note is the maturity most sensitive to Fed policy, its disconnect from the performance of longer-term bonds indicates that investors are already positioning for rate hikes. The fact that investors are shifting their portfolios this far in advance greatly reduces the odds of a crash, which typically only occurs when investors all try to hit the exit door at the same time.

The Fed Is Watching the Markets Closely

It’s also important to keep in mind that it’s in the Fed’s best interest not to take any actions that will lead to a bond market crash. Any decision that would disrupt the financial markets would feed through into the economy, which in turn would force the Fed to adjust its policy.

Since the Fed wants to avoid that outcome, obviously, it is making every effort to communicate its policy decisions and prepare the markets for the timing and extent of its interest-rate increases. This eliminates the element of surprise, which – as noted previously – reduces the odds of a crash.

Overseas Pressures Are Keeping a Lid on Rates

As discussed here, the U.S. bond market doesn’t operate in a vacuum: economic conditions and bond market performance overseas have a direct effect on our market. And right now, Europe’s economic slowdown – and a possible slide into dangerous deflationary territory (i.e., prices falling rather than rising) - has driven down yields across the Continent. This makes the relatively higher yields in the U.S. Treasury market more attractive, and it creates a wellspring of demand that will bring in buyers if yield rises rapidly. The takeaway: as long as Europe is struggling, the odds of a bond market crash in the United States are very low.

Investors Are Conditioned to a “Crash” Mentality

This is an underrated factor in discussions about the bond market. Many investors have lived through the stock market crashes in 2001-2002 and 2007-2008, and much more experienced the intense bond market sell-off that occurred in spring 2013. These events have fostered an undercurrent of fear among investors, and this fear is fed by the endless stories of potential crashes in stocks, high yield bonds, investment grade bonds, etc.

The reality is that an article titled, “More of the Same” won’t get any readership, but one that’s titled “Why a Market Crash is Imminent!” certainly will. Individual investors, therefore, need to take discussions of potential market calamities with a (very large) grain of salt.

The Bottom Line

Add it up, and a crash is highly unlikely. A protracted period of lower returns is almost certain, higher volatility is probable, and a bear market may well be in the cards. However, the odds are heavily against the type of calamity you’ll often see discussed in the financial press. So consider ways to position your portfolio for the changing environment, but don’t let the fear of a bond market crash get the better of you.