First they came for the yield, then they came for the duration.
A Goldman Sachs Group Inc. analysis says investors could be mired in a world of pain if yields on long-dated assets snap higher. Just a modest backup in rates could inflict outsized losses on bond portfolios – a sobering prospect in light of the recent jump in longer-dated bond yields that's already eating into bondholders' capital returns.
A 1-per-cent increase in interest rates could inflict a $1.1-trillion (U.S.) loss to the Bloomberg Barclays U.S. aggregate index, analysts at Goldman calculate, representing a larger loss for bondholders than at any other point in history. With the bank predicting the sell-off in bonds has further to run, that remains "far from a tail scenario," its analysts write.
Bets on longer-maturity obligations had paid off handsomely for most of the year amid a global bond rally triggered by expectations that weak economic activity will persuade central banks in advanced economies to postpone tightening monetary policy. Asset purchases by the Bank of Japan, Bank of England and the European Central Bank helped the average maturity of new U.S. corporate bonds climb to a peak of 11.3 years in August. With average bond maturities worldwide now more than double the inflation-adjusted level of 2009, and three times that of 1994, Goldman says there's an elevated risk of losses if rates spike higher.
"We see potential for the rates market to continue to sell off, and the notional amount of duration dollars at risk is unprecedentedly large," Goldman fixed-income analysts, led by Marty Young, wrote in the report on Monday.
The effective average duration of the global bond market, as measured by the Bloomberg Barclays global aggregate index, has risen to 6.98 years, as of mid-October, compared with 6.60 years in January. Goldman's $1-trillion estimate reflects potential losses on U.S. dollar-denominated investment-grade cash bonds and therefore may form a conservative estimate of the risks facing money markets. It excludes a whole gamut of duration risks facing the U.S. interest-rate swap market; from junk obligations, to the trillion-dollar pile of fixed-rate mortgages and corporate loans held on bank balance sheets.
A tug-of-war between valuation concerns and dovish central banks will drive the near-term outlook for yields on long-dated securities. Bond guru Bill Gross – who's also warned that minor interest-rate moves have the potential to wipe out capital gains on bond portfolios – said last month the timing for any "bond bear market" had been "delayed" thanks to dovish central-bank pronouncements, which provide a fillip for longer-dated debt. Goldman last month, however, downgraded bonds to underweight on a three-month time horizon, while maintaining its overweight position for cash, partly owing to sell-off pressure it said valuation and monetary-policy concerns pose to U.S. sovereign debt.
In their Monday note, Mr. Young and team restate their view that U.S. long-dated notes could snap higher in the coming months, noting that 10-year U.S. Treasury yields appear expensive relative to fundamentals to the tune of 1.5 standard deviations.
Fed-tightening cycles in the 1990s and in 2006 caused longer-dated bond prices to fall more relative to shorter-dated obligations. Investors typically demand greater compensation for longer-duration bonds, since there's a greater probability interest rates will change over their lifetime.
Still, the ownership of long-dated debt provides a modicum of solace. "Duration risk is more widely owned today, especially by global central banks and sovereign wealth funds which can more readily absorb such a shock," the analysts conclude. Foreign central banks and sovereign wealth funds – who this year have shunned new U.S. government debt purchases – face the biggest mark-to-market losses in the event of an interest-rate shock, the Goldman analysts conclude, since they are large buyers of such securities. Meanwhile, pension funds, the natural buyers of bond obligations with longer maturities, would see a corresponding reduction in their liabilities, offsetting, to some extent, the impact of rising rates.
So while Goldman doesn't necessarily foresee a systematic shock if interest rates snap higher, price-sensitive long-duration investors are swimming in uncharted waters.