Investors could be surprised if interest rates begin to move higher, which is why the US Federal Reserve should take a gentle approach so as not to disrupt “price sensitivities” in the bond market. Prices can be particularly sensitive due to mechanical factors that typically get overlooked during periods of low volatility, Bridgewater Associates founder Ray Dalio wrote in a September 15 strategy note obtained by ValueWalk. Understanding why the increasing price sensitivity underlies today’s bond portfolios provides insight into performance drivers behind a traditionally significant portfolio diversifier.
Watch out for "the potential for relatively big losses in bonds"
Understanding Dalio’s latest strategy observation requires context. In the report titled “The Mechanics of the Markets, Why Investors Will Be Shocked When Interest Rates Start Rising,” Dalio notes the US Federal Reserve must be very careful when raising interest rates. Very careful.
“The potential for relatively big losses in bonds worries us because bonds effectively haven’t had a bear market in decades,” he wrote. “The vulnerabilities to that sort of a move haven’t been tested."
In this environment, Dalio has words of caution for Janet Yellen and the US Federal Reserve. "Be very cautious about tightening, and avoid tightening much faster than what markets are pricing in.”
When the rate of price change in bonds is low, as has been the case over the last few years, investors typically focus on the yield aspect of a bond return. As yields move lower, diminishing investor's return, the bond price sensitivity also rises which can impact a portfolio. When investors start to see their yield practically disappear as a result of negative price appreciation, those investors begin to shift returns attribution focus to bond price. If bonds start to move in a negative fashion, the impact could be magnified.
How significant is this?
In developed world countries, a slight 1% increase in interest rates could result in a 9% loss in the bond’s price, the highest sensitivity levels in several decades. This price sensitivity is is higher by nearly 1/3 from a decade ago when a 1% rise in interest rates would have led to a 6% loss in bond prices, for instance.
Why is their enhanced price sensitivity to bonds in the current environment?
Driving the increased sensitivity to price are several mechanical factors particular to the bond contract structure and changes in portfolio composition.
Not only do prices become mechanically more sensitive when yields move close to zero, but there is the shifting nature of duration. As global governments have generally issued more longer-dated bonds, the average time horizon in portfolios has increased. The longer end of the yield curve has a significantly higher degree of price sensitivity. As portfolios embrace longer duration bonds they are also increasing the portfolio's relative volatility tolerance.
In addition, government debt levels are at all-time historic highs. Higher debt levels result in increased price sensitivity. This leads to powerful performance drivers moving prices.
"We want to point out that what is also happening in capital markets is the classic 'carry-price change trap,'" Dalio wrote. "It happens when investors focus on the carry and pick higher-yielding assets, which drives them up so that price movements work in their favor."
Seperate analysis points to price momentum being cyclical in nature. At some point all trends end.
“This goes on until there is a price correction,” Dalio wrote. It is at this point “everything changes and a self-reinforcing reversal takes place.”
Dalio on interconnectedness of bond yields to other asset prices
The larger performance drivers of the debt supercycle aside, Dalio, as if operating out of the noncorrelated investment manager playbook, brings the discussion from the macro-economic outlook to market probability paths and risk management.
The slight 1% move in yields that Dalio modeled is not their base case necessarily. Yield moves of more than one percent “were commonplace until recently.”
Interest rates moving higher will not occur in a vacuum. The vulnerabilities are not just in the bond market, but stocks, too, will be negatively impacted. “The next downturn may be a difficult one for central banks to reverse.”
While Dailo says Bridgewater is not sure when or how quickly interest rates will rise, when they do those long bonds are at risk for a steep price decline which will reverberate into the stock market.
There is clear and logical risk in the air. As a noncorrelated investment manager, Bridgewater has two responsibilities: analyze risk and markets without emotion or bias; then execute the proper noncorrelated strategy to manage both positive and negative market environments. How this is executed will be more than interesting to watch.