Taper Tantrum Redux

After a brief reprieve at the end of last week (May 4–8, 2015), the global bond sell-off resumed Monday, May 11, 2015, with 10- and 30-year Treasury yields rising to year-to-date highs of 2.28% and 3.04%, respectively. Treasury yields have now broken out of their recent ranges and have done so quickly.

The bond market pullback has been fast and furious and, so far, ranks among the sharpest corrections over such a short period of time. Since European bond weakness sparked selling on April 20, 2015, longer-term bonds have borne the brunt of selling with 10- and 30-year yields rising by 0.41% and 0.52%, respectively, while shorter-term bonds have been more insulated from price declines.


Looking back at the major bond pullbacks of the past 15 years shows that the current correction is among the swiftest. The ongoing pullback is on pace, and of similar magnitude, to the 2003 mortgage-backed securities (MBS) related sell-off [Figure 1]. That makes the current sell-off more severe than the taper tantrum in terms of speed but has a way to go to match the magnitude. A lopsided position imbalance sparked the 2003 pullback as MBS portfolio managers sold Treasuries to offset price declines in their MBS portfolios. When interest rates rise, MBS prepayments typically decline, as homeowners are less likely to refinance their underlying mortgages. The average life of MBS “extends” or essentially becomes a longer-maturity bond, and MBS portfolios hedge, or protect against this risk by selling Treasuries. Since the MBS sector comprised nearly 40% of the broad Barclays Aggregate Bond Index, a further increase in interest rates required additional hedging, and subsequent selling of Treasuries. The selling fed on itself as further losses sparked additional selling to protect against MBS declines.

Similar to 2003, position imbalances may be exacerbating price declines now. A surge in corporate bond issuance has likely contributed to bond weakness as bond dealers sell Treasuries to protect against losses on new issue corporate bond balances. Historically, periods of heavy new corporate bond issuance can weigh on investment-grade corporate bonds over short periods of time [Figure 2]. When the four-week moving average of investment-grade corporate bond issuance exceeds $30 billion, it has often sparked headwinds for performance. On a single-week basis, the week of May 4, 2015, witnessed over $50 billion in new investment corporate bonds, only the fifth week over the past year where weekly issuance exceeded $50 billion.

Additionally, as we discussed last week’s Bond Market Perspectives publication (“Made in Europe,” May 5, 2015) a heavy concentration of long-term Treasuries has restrained bond dealers from actively participating in financial markets. Position imbalances can wreak more havoc in such an environment. In overnight trading on May 7, 2015, both German Bund yields and Treasury yields spiked higher by 0.12% to 0.18%, before finishing the day unchanged to modestly positive. The quick, rapid movement was similar to the Treasury “flash crash” incident of October 2014, which was investigated by the U.S. Treasury and witnessed even greater intraday volatility. The lack of liquidity in bond trading may be playing a role once again.


No economic catalyst has been directly responsible for bond price declines. U.S. economic data have been mixed at best in recent weeks, culminating with last week’s good but not great monthly jobs report for April 2015, and consensus forecasts for second quarter 2015 economic growth have edged lower. Rising long-term yields may signal better growth, but growth-related bond sell-offs are rarely quick and sharp.

Fed rate hike expectations reached their lowest levels of 2015 last Friday, May 8, 2015, as measured by fed fund futures, with a first rate hike not fully priced in until January 2016. This is the most benign signal to date. Recent weakness, therefore, cannot be attributed to fears over pending interest rate increases and, along with the absence of an economic catalyst, point to a position imbalance driving weakness.


Lower-rated bond sectors have performed best during this challenging period [Figure 3]. Historically, high-yield bonds and bank loans have performed best during periods of rising interest rates and have done so again recently. Emerging markets debt was resilient due to a reduction in Fed rate hike fears, a weaker U.S. dollar, and moderately attractive valuations. But following recent improvement, EMD will likely face greater headwinds. U.S. dollar weakness was a primary driver of unhedged foreign bond performance. Lower yields provide less protection against rising interest rates and the impact is reflected in hedged foreign bond exposure, which was among the weakest sectors globally. We continue to recommend that investors avoid developed foreign bonds, and we find high-yield bonds or bank loans in conjunction with high-quality intermediate bonds the best way to manage the current environment.

Caution is prudent as high-yield bond performance, while still positive, is low and reflects the headwinds of rising interest rates. The decline in high-yield bond yields provides less protection as well. A lower allocation to bonds overall may still be warranted given the lack of opportunity and reduced protection offered by still historically low yields and high valuations. The end of any significant bond market sell-off, or rally for that matter, is nearly impossible to time, and pullbacks driven by poor liquidity and position imbalances are especially challenging. No standout opportunity has emerged as of yet, in our view, to spark a rebound; but European futures show a small probability of a European Central Bank rate hike, which we find misguided and perhaps the first sign of an extreme that may signal an end to the pullback.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indexes are unmanaged and cannot be invested into directly.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise, and bonds are subject to availability and change in price.

Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.

Investing in foreign fixed income securities involves special additional risks. These risks include, but are not limited to, currency risk, political risk, and risk associated with foreign market settlement. Investing in emerging markets may accentuate these risks.

High-yield/junk bonds are not investment-grade securities, involve substantial risks, and generally should be part of the diversified portfolio of sophisticated investors.

Mortgage-backed securities are subject to credit, default, prepayment risk that acts much like call risk when you get your principal back sooner than the stated maturity, extension risk, the opposite of prepayment risk, market and interest rate risk.

Corporate bonds are considered higher risk than government bonds but normally offer a higher yield and are subject to market, interest rate, and credit risk as well as additional risks based on the quality of issuer coupon rate, price, yield, maturity, and redemption features.

Different agencies employ different rating scales for credit quality. Standard & Poor’s (S&P) and Fitch both use scales from AAA (highest) through AA, A, BBB, BB, B, CCC, CC, C to D (lowest). Moody's uses a scale from Aaa (highest) through Aa, A, Baa, Ba, B, Caa, Ca to C (lowest).


The Barclays U.S. Aggregate Bond Index is a broad-based flagship benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS, and CMBS (agency and non-agency).

Barclays U.S. High-Yield Loan Index tracks the market for dollar-denominated floating-rate leveraged loans. Instead of individual securities, the U.S. High-Yield Loan Index is composed of loan tranches that may contain multiple contracts at the borrower level.

The Barclays U.S. Corporate High-Yield Index measures the market of USD-denominated, noninvestment-grade, fixed-rate, taxable corporate bonds. Securities are classified as high yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below, excluding emerging market debt.

The Barclays U.S. Corporate Index is a broad-based benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate, taxable corporate bond market.

The Barclays U.S. Mortgage Backed Securities (MBS) Index tracks agency mortgage backed pass-through securities (both fixed rate and hybrid ARM) guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC)

The Barclays U.S. Municipal Index covers the USD-denominated long-term tax-exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds, and pre-refunded bonds.

The Barclays Municipal High Yield Bond Index is comprised of bonds with maturities greater than one-year, having a par value of at least $3 million issued as part of a transaction size greater than $20 million, and rated no higher than ‘BB+’ or equivalent by any of the three principal rating agencies.

The Barclays U.S. Treasury Index is an unmanaged index of public debt obligations of the U.S. Treasury with a remaining maturity of one year or more. The index does not include T-bills (due to the maturity constraint), zero coupon bonds (strips), or Treasury Inflation-Protected Securities (TIPS).

The Citi World Government Bond Index (WGBI) measures the performance of fixed-rate, local currency, investment-grade sovereign bonds. The WGBI is a widely used benchmark that currently comprises sovereign debt from over 20 countries, denominated in a variety of currencies, and has more than 25 years of history available. The WGBI provides a broad benchmark for the global sovereign fixed income market. Sub-indexes are available in any combination of currency, maturity, or rating.

The JP Morgan Emerging Markets Bond Index is a benchmark index for measuring the total return performance of international government bonds issued by emerging markets countries that are considered sovereign (issued in something other than local currency) and that meet specific liquidity and structural requirements.

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