Worse than 1994 ‘Bond Massacre’ predicted
If you thought you had already read the gloomiest possible prognosis for bonds, wait until you read this one. Paul Schmelzing, a PhD candidate at Harvard University and a visiting scholar at the Bank of England, said if the latest bond market bubble bursts, it will be worse than in 1994 when global government bonds suffered the biggest annual loss on record.
“Looking back over eight centuries of data, I find that the 2016 bull market was indeed one of the largest ever recorded,” wrote Schmelzing in an article posted on Bank Underground, which is a blog run by Bank of England staff. “History suggests this reversal will be driven by inflation fundamentals, and leave investors worse off than the 1994 ‘bond massacre’.”
Schmelzing, whose research focuses on the history of international financial systems, divided modern-day bond bear markets into three major types: inflation reversal of 1967-1971, the sharp reversal of 1994, and the value at risk shock in Japan in 2003.
The Bank of America Merrill Lynch Global Government Index of bonds fell 3.1 per cent in its worst-ever annual loss in 1994 as then-Fed Chairman Alan Greenspan surprised investors by almost doubling the benchmark rate. more than $35 billion in sales. Yankee issuers, which are foreign finance firms with operations in the US, accounted for a large portion of the financial deals.
Volume could continue to remain strong through the first quarter because of pent-up demand, issuers looking to frontrun rising interest rates and the uncertainty of a new administration. The funding landscape has changed, with Treasury yields climbing in the last quarter of 2016 and projected to continue rising this year. Higher rates diminish the appeal for opportunistic issuers that have become accustomed to raising cash cheaply.
Now, three more hikes are planned for 2017, likely accelerating plans for issuers that want to tap the market before financing costs rise. The market is pricing in a 48 per cent chance of a rate increase by May and a 73 per cent chance of one by June.
A projected decrease in funding for mergers and acquisitions could further crimp issuance totals. M&A has been the main driver of record breaking investment-grade bond sales over the past two years, so a slowdown in activity would throw a wrench in that.
Moreover, if President-elect Trump slashes the tax rate to repatriate corporations’ overseas cash, certain companies, especially from the tech sector, may slow down their debt issuance or decide not to issue at all.