- Duration Risk: The Bomb Ticking Inside Today’s Bond Market
Japanese bond market shows quiet risk lurking in era of low and negative rates
By
Mike Bird
April 14, 2016 5:30 a.m. ET
Investors looking for big, bold returns in government bonds could have found them in two very different places over the past year: Venezuela and Japan.
Venezuela’s case is a familiar story to those who rummage around the dicier corners of the bond market: There were substantial questions about whether Venezuela would have the cash to repay a bond that came due on Feb. 26. It did, and an investor who took the risk of buying it a year earlier would have earned a 27% return.
Japan is less obvious, and it highlights a quiet risk suffusing bond markets in the era of low and negative rates: duration.
The duration of a bond is a measure of when an investor gets his or her money back. Longer-term bonds have higher duration—as do bonds with lower coupon payments, because low coupons mean more waiting.
Today, with global interest rates extraordinarily low, and borrowers issuing ultralong debt, duration is shooting up.
Duration implies risk: A rule of thumb is that a one percentage-point change in interest rates implies a change in the bond’s price equal to the duration. A bond with a duration of 25 years will jump 25% if interest rates fall by one percentage point?and fall 25% if rates rise by the same amount.?
Japanese debt is a prime example.
Last year, Japan issued a 40-year bond with a coupon of 1.4%. Rates have fallen in Japan, and so the price has risen 34%.
As durations get longer, risks mount.
France on Tuesday issued a 50-year bond with a coupon of 1.75%. Before the eurozone debt crisis, France was issuing similar bonds with coupons of 4%.
An investor who bought the earlier bond would get his or her money back in the form of coupon payments much faster—collecting the face value of the bond in 25 years. An investor who bought on Tuesday wouldn’t collect enough coupons to recoup the face amount before the bond matures.
That long waiting period is worrisome.
An educated investor can take a guess at where interest rates might be in two or three years and the situation that the economy might be in then. That is the sort of range that many central banks and other large institutions attempt to forecast across, and many end up being inaccurate. A forecast of the world in four decades is a fool’s errand.
Usually, to account for duration risk, the yield curve on bonds is relatively steep. That means bonds with long maturities have considerably higher yields, since an investor is facing considerable uncertainty.
In Japan and increasingly in Europe, yield curves are flattening. Investors who usually might have opted for shorter-dated government bonds in Japan have been driven into more distant maturities.
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The yield on a 40-year Japanese bond has declined from above 2%, when Prime Minister Shinzo Abe’s adventurous economic stimulus began in late 2012, to around 1.5% at the end of 2015. Since the Bank of Japan 8301 1.76 % ’s negative rate announcement, it has plunged to below 0.5%.
Few are predicting a turnaround in Japanese rates any time soon. But 40 years is a long time to wait, and if rates do turn, investors holding the bond will be in trouble—even though Japan’s government debt is regarded as some of the world’s safest.
If rates rise, a bond yielding 0.49% becomes unattractive, and an investor must take a loss to sell it.
Though the flatter yield curves are a consequence of monetary stimulus designed to give the economy a boost, they are also a major problem for financial institutions that make their profit in the window between short-term liabilities and long-term assets.
In February, the largest net buyers of Japanese government bonds with maturities over 10 years were Japanese insurance companies, according to Shuichi Ohsaki, chief rates strategist at Bank of America Merrill Lynch in Japan.
Insurance companies, particularly life insurers, need long-term assets to match their long-term liabilities.
The European Central Bank cut its official deposit rate into negative territory in 2014, reducing it to minus 0.4% and expanding its quantitative easing, or QE, program in its March meeting this year.
And duration has risen steadily in Europe. The duration of the iBoxx euro sovereign index, which tracks eurozone government bonds, has risen to 7.2 years, according to financial data firm Markit. That’s up from less than five years in 2006 and about six years until as recently as 2011.
Still, prodding investors out of the market for sovereign debt is a main goal of Europe’s and Japan’s monetary easing.
But institutions which have made government bonds the backbone of their business model, like insurance companies and pension funds, may struggle to find safe alternatives with a similar yield.
Those investors and fund managers are forced to take on more risk. When that is through credit risk, as in the case of Venezuelan government bonds, it seems obvious to everyone. When they are loading up on bonds that don’t mature for longer and longer periods, it is less easy to see. But the risk is still there and growing.
Write to Mike Bird at mike bird@wsj.com
wsj.com
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Fred Charette 5ptssubscriberFeatured
4 days ago
Negative interest rates are just the latest central bank insanity. Their monumental conceit is that a nation can borrow its way to prosperity.
It's a massive confiscation of wealth from older prudent savers, the source of all funds for investment and wealth creation, and transfer to corrupt politicians and younger profligate borrowers, e.g., the $1.5 Trillion student loan scam 40% of which are in default.
Even Berntsen
Even Berntsen 5ptssubscriberFeatured
5 days ago
It’s like trying to look into the universe and discern unknowns. We are indeed on a path to a great unknown in terms of timing, but as Ponzi schemes goes it will not end well. The disparity between annual compounding growth in global debt of above 13% over past 10years and gdp of below 6% has eliminated any tangible near term benefits from extra borrowings to growth making these lower or negative interest rates rather harmful.We are left with just a rise in risk and a stay of execution by desperate central bank policies preventing any sort of cleansing necessary to rejuvenate future growth and returns.
Richard Olson
Richard Olson 5ptssubscriberFeatured
6 days ago
I think the very saddest story here about duration risk is yet to come with millions of US investors who have been sold financial plans that recommended a high proportion of investments in fixed income vehicles and bonds. Typically a retired investor may have been advised to hold 50% of assets in investment grade bond funds, which also may have long durations. Today, this financial planning advice is really bad news with such extreme low interest rates, and when the day comes that interest rates go back to historical levels, these poor investors are going to be crushed. And many of them are basically locked in to financial advice that is no longer relevant in a low interest rate environment. Anyone getting a 3% yield for example on a investment grade bond fund today may be protected from default risk, but when rates go up, the capital losses from duration risk may be substantial. And my guess is that many investors are locked up in bond funds today.
Mike Lopus
Mike Lopus 5ptssubscriberFeatured
5 days ago
@Richard Olson most bond fund have duration that is less than or equal to that of the Barclay's Capital Aggregate index which is around 5.5 years. Long term bond funds are not a staple in most individual investment portfolios recommended by financial advisors. So the greater risk in most cases is not from capital losses when rates rise but rather from the risk that the current rate environment is the "new normal" and you will never get much more than the current yield in the bond market (which is approximately 2.25% for the Agg). For current retirees, extended zero or negative interest rate policies are the greater risk to their retirement viability.
1ROBERT N DAVIS
Richard Olson
Richard Olson
5 days ago
@Mike Lopus @Richard Olson
Thanks for the reply.
Look at 3 different scenarios here about what could happen to interest rates.
One is even lower rates, you probably would agree that this is bad for retirees
Second is flat rates. Let's say rates stay flat for 5 years. This means at your assumed 2.25% average yield a retiree gets 11% income total, which a bit more than current inflation.
Third is rising interest rates. Let's say they go up 300 basis points over 5 years. This implies a 17% capital loss using your assumed duration of 5.5 years.
Seems to me that the flat scenario is best. You would have to explain further how a 17% capital losses is better for retirees who might collect 11% income over that period of 5 years. And if rates do rise here, my guess is that with the illiquidity introduced by Dodd Frank regs mean that bonds might go down much more than anyone expects. If there is a massive bond redemption, heaven help bond fund managers who can't find bond buyers.
Mike Lopus
Mike Lopus 5ptssubscriberFeatured
5 days ago
@Richard Olson @Mike Lopus In order to suffer the 17% loss, the rate rise would have to happen all at once. That means that the retirees are now able to invest at a prevailing yield of 5.25% rather than 2.25%. Over 5 years they would be slightly behind where they would have been in the flat yield environment. By year six (and beyond), they are actually better off having taken the hit to capital all at once and then reinvested at higher prevailing rates. Since most retirees have a time horizon well beyond 6 years, a sharp rise in rates (assuming that they do not have to sell huge portions of their principal in the first year or two (which they should not is they are holding appropriate cash reserves)), followed by an ability to earn higher prevailing rates actually leaves them ahead of the flat rate environment. Emotionally it may feel worse as they see their account value adjusted down all at once, but financially, they end up better off over the long run. quick pain - long gain
1Diane Sacchetti
Richard Olson
Richard Olson 5ptssubscriberFeatured
5 days ago
@Mike Lopus @Richard Olson Yeah I suppose that there actually are some financial advisors who have enough control over their clients that they could say eat a big capital loss now and you will be better off if you stick with me. Take my word for it.
To tell someone they are going to have to wait 6 years to breakeven and "hope" for the best in some extended financial scenario seems a bit of a stretch to me. I don't think I would employ that advisor.
FYI. If you talk to most bond portfolios managers and ask what would happen to bond prices in a scenario where redemptions are expedited due to rising interest rates in a bond market with reduced liquidity, I think you would learn the 17% capital loss is way underestimated. Price to duration sensitivity has been based on scenarios where interest rates started at a much higher point than current levels. Whatever way you roll it out, this is going to be a glum time for financial advisors dealing with befuddled fixed income clients.
Michael H Mitchell
Michael H Mitchell 5ptssubscriberFeatured
5 days ago
@Mike Lopus @Richard Olson Who knows what the future holds. If we knew, we would all be extremely wealthy. I've been hearing variations of this scenario for seven years now. Nothing has happened yet.
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(closing bit : who knows what evil lurks in the heart of man: Only the Shadow Knows.)
old time radio theme......
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