What Happens During a Bond Market Crash?
When the bond market crashes, bond prices plummet quickly, just as stock prices fall dramatically during a stock market crash. Bond market crashes are often triggered by rising interest rates. Bonds are loans from investors to the bond issuer in exchange for interest earned. When the Federal Reserve increases interest rates, bond prices typically fall in the short term. Investors look at a bond’s interest payments, known as a bond coupon, to determine how much they’re willing to pay for the bond. When interest rates rise, investors can earn more money from newly issued bonds, so the price of existing bonds that pay lower interest rates drops. When interest rates rise rapidly, bond prices may fall quickly, leading to a crash. A general rule is that a one percentage point change in interest rates would move the bond price in the opposite direction to the tune of its duration number. The duration number measures the sensitivity of the bond’s price to a change in interest rates. The duration number is calculated using factors such as the time to maturity and the coupon rate. The larger the coupon rate, the shorter the duration, and the longer the maturity, the longer the duration. For example, for a bond with a 10 year duration, a one percentage point increase in interest rates will lead to a 10% decline in price.
Causes of a Bond Market Crash
Bond market crashes can occur for a number of reasons, but two common causes are bond bubbles and actions by the Federal Reserve.
Bond Bubbles
A bond market bubble is when bond prices soar above their fundamental values for a prolonged time period. The subsequent price crash that follows is often referred to as the bursting of the bubble. Bond yields and bond prices move in opposite directions. Historically low Treasury yields (return on government bonds) may be a sign of a bond bubble. For example, in March 2020, the 10-year Treasury yield plummeted below 1%, an unprecedented low in recent history. The drop occurred as panic around the COVID-19 pandemic set in and investors sought safe-haven from the stock market in government-issued bonds. High demand for bonds pushes their prices higher, putting a downward pressure on yields.
Fed Rate Increases
In a rising interest rate environment, existing bonds must trade at lower prices to compete with newer bonds that offer higher coupon payments. Conversely, when the Fed lowers interest rates, bond prices rise because existing bonds pay a premium compared to newer bonds.
How a Bond Market Crash Affects the Stock Market
Theoretically, bond prices and stock prices have an inverse relationship in the short term. When the stock market crashes, investors often flock to bonds, whereas a bond market crash would typically cause investors to move money into stocks. Bond prices drop in response to rising interest rates because investors can earn more from newly issued bonds than existing issuances. Rising interest rates also makes borrowing more expensive for both consumers and businesses alike. That impacts consumer spending and business activity, which in turn affects corporate earnings and drags down stock prices. So both kinds of financial markets are hit.
What To Do During a Bond Market Crash
When bond markets crash, it may induce panic among investors, especially since bonds are supposed to be a relatively less risky investment. As bond prices drop, the value of your investment in a bond or a bond fund goes down. But panic selling bonds just because prices crash in the short term will leave you worse off in the long run. Also remember, bonds are typically long-term investments that will continue to give you regular coupon payments. So don’t let short-term volatility phase you. Just like you’d do with stocks, it’s generally a good idea to diversify your bond portfolio. You don’t have to wait for bond market volatility to do that. Diversification means you allocate your money across different types of bonds of varying maturities and risk profiles. For example, U.S. treasury bonds are considered less risky than corporate bonds. A good mix of short, medium, and long maturity bonds can help mitigate some of the interest risk to your bond portfolio. According to asset management company AllianceBernstein, a good rule of thumb to keep in mind is if the duration of your bond portfolio is shorter than your investment time horizon, rising interest rates will benefit you irrespective of how much the rates rise by.Additionally, if you expect interest rates to rise, you could employ investment strategies such as bond ladders, that use bonds of differing maturities to maintain a steady stream of income while minimizing the impact of the rate hikes.
History of Bond Market Crashes
Bond market crashes often generate less attention than stock market crashes. However, they’ve occurred at several points in history. Here are some examples.
Great Bond Massacre of 1994
In February 1994, the Federal Open Market Committee surprised investors by voting to increase the target federal funds rate by 25 basis points, the first target rate increase since 1989. The Fed didn’t communicate its intention well and the announcement surprised the market, triggering a bond sell-off. As the bond market crashed, the 10-year Treasury yield shot up from a little over 5% in late 1993 to a shade higher than 8% by late 1994. Bond investors, including banks and pension funds, sustained major losses as a result.
‘Taper Tantrum’ of 2013
Central banks like the Fed often stimulate economic growth by purchasing U.S. government bonds and mortgage-backed securities, which reduces the supply for investors. Bond prices rise and yields drop as a result. When the economy recovers, the Fed winds down such asset purchases in what is called “tapering.” Tapering these purchases signifies that the Fed is reducing economic stimulus and typically precedes an interest rate hike. A sudden reaction in the financial markets is known as a taper tantrum. The Fed engaged in such a bond buying program to help the economy get back on its feet after the Great Recession. In May 2013, then Federal Reserve Chairman Ben Bernanke mentioned the central bank’s intention to taper while he testified before the Congress. Since Bernanke’s initial statement did not clarify how the Fed would go about the process, the markets reacted sharply and bond prices tanked. As a result, the 10-year Treasury yield spiked from about 2% in May 2013 to 3% in December 2013.
Bond Market Crash of 2022
The Fed had to engage in asset purchases again in the aftermath of the short recession in 2020. It announced that it would begin tapering asset purchases in November 2021. In the year that followed, rising inflation forced the Fed to hike interest rates seven times. As a result, 2022 was a bad year for bond investors. The Bloomberg Barclays US Aggregate Bond Index, which represents the vast majority of the investable U.S. bond market, dropped nearly 13% in 2022. Adding to the pain for ordinary investors, the S&P 500 index—a benchmark for U.S. stocks—fell by 19.44% during the year.
