Prominent Victims

Hegde fund legend Ray Dalio among other things runs a big fund that is called the 'All Weather Fund'. Its appeal is based on the idea that by holding different investments that will either profit from rising or falling inflation, it will deliver positive returns no matter what happens.

What the fund's managers obviously didn't expect was the scenario that has actually unfolded lately: inflation expectations are collapsing, and bond yields are shooting higher anyway. And so the 'All Weather' portfolio is now suddenly under the weather:


“A $70 billion portfolio managed by hedge fund titan Ray Dalio's Bridgewater Associates and widely held by many pension funds to survive stormy markets is emerging as a big loser in the recent selloff in global markets.

The Bridgewater All Weather Fund is down roughly 6 percent through this month and down 8 percent for the year, said two people familiar with the fund's performance.

The All Weather Fund is one of two big portfolios managed by Bridgewater and uses a so-called "risk parity" strategy that is supposed to make money for investors if bonds or stocks sell off, though not simultaneously. It is a popular investment option for many pension funds and has been marketed by Bridgewater and Wall Street banks as way to hedge market turmoil.

Bridgewater created a portfolio based on two of the four basic economic scenarios: rising growth, falling growth, rising inflation, falling inflation. Different types of assets do well in each of these scenarios and the all-weather portfolio contemplates spreading its risk evenly.

But money managers familiar with the strategy said it does not perform when both stock and bond prices tumble, as global markets have experienced in recent weeks.


The All Weather fund invests heavily in Treasury inflation protected securities, or TIPS, which have lost 4.5 percent in June and over 8.26 percent year-to-date. In fact, the All Weather fund, launched in 1996, was a leader in investing in inflation-protected bonds.

Rick Nelson, chief investment officer for Commonfund, with $25 billion under management for endowments and foundations, said his firm has avoided putting clients into risk parity funds because there are better ways to manage risk.

He said risk parity funds tend to "use a great deal of leverage on the fixed income side" and that can magnify losses. Nelson was not commenting specifically on All Weather because Commonfund has no money with Bridgewater.”


(emphasis added)

This is precisely what we have frequently stressed in recent commentaries on the slaughter in bond markets: many bond investors use inordinate amounts of leverage to magnify the tiny yields that have been left over after years of massive central bank intervention. And this is ultimately why it was possible for yields to spike in spite of falling inflation expectations. Leveraged investors in inflation-protected securities presumably lost so much money (along with their brethren in the submerging markets debt space), that their losses triggered selling in other bonds, and this then began to spread out until it hit equities as well. It shows that as a result of central bank interventions, prices of securities can become completely unmoored from underlying fundamentals, simply because so much debt is in play.





TIPA weekly chart of the TIP ETF. Such a price crash tends to be magnified in leveraged portfolios – click to enlarge.



A loss of 6% for the month and 8% for the year is not the end of the world for Mr. Dalio, even though 8% of 70 billion are a hefty $5.6 billion. 8% is nothing compared to the total destruction that has e.g. hit Mr. Paulson's gold investments. However, if even a well-known dodger of bullets such as Mr. Dalio is hit hard by this recent bond market swoon, one can imagine that a number of lesser players must have been totally crushed. Hence the recent escalation in forced selling, which has at least temporarily abated in a number of vehicles over the past two days (the only markets in which selling continues at full blast are so far the precious metals).



EMBEMB has begun to bounce after its recent crash – click to enlarge.



MUBMUB is bouncing as well – click to enlarge.



Of course these bounces look more like short covering after severely oversold conditions were reached than genuine recoveries at this point. At a minimum one should probably expect a retest of the lows at some point.


Bond Losses Hit Banks Where it Hurts

Somewhat more worrisome is the devastation the recent swoon in bonds has inflicted on bank balance sheets. Banks are not only suffering from the big decline in government bonds, but the concurrent decline in the value of mortgage backed bonds. Consider for instance one of the structured finance vehicles that can be used for speculation on the 'housing recovery', the Markit ABX-HE 06 AA index (which can be regarded as a proxy, direction-wise, for other indexes of its kind):



Quite big chunk of recovery has been given back.



Since banks no longer need to mark their paper losses to market (the famous FASB extend and pretend measure introduced in April of 2009), this allows us an indirect glimpse at the ups and downs in the value of some of their holdings. Note though that this does not apply to 'securities held for sale' (see also further below). As an aside to the above: speculation in any of the structured housing finance vehicles rated A or lower has long ceased. Most of the ABX-HE indexes reflecting pools with such ratings trade at or close to all time lows.

The BIS has noted that bond market losses in the US alone could approach $1 trillion if yields were to rise by three percentage points and lambasts practically everyone for not having “made use of the time provided by easy money policies to get their fiscal houses in order” (a download link to the complete BIS annual report is at the end of this article).


“Bondholders in the United States alone would lose more than $1 trillion if yields leap, showing how urgent it is for governments to put their finances in order, the Bank for International Settlements said on Sunday.

The Basel-based BIS lambasted firms and households as well as the public sector for not making good use of the time bought by ultra-loose monetary policy, which it said had ended up creating new financial strains and delaying rather than encouraging necessary economic adjustments.

The BIS, a grouping of central banks, was one of the few organizations to foresee the global financial crisis that erupted in 2008. Since then, government bond yields have sunk as investors seek a traditionally safe place to park funds, regulators tell banks to hold more bonds and central banks buy bonds as a means of pumping money into vulnerable economies.

The BIS said in its annual report that a rise in bond yields of 3 percentage points across the maturity spectrum would inflict losses on U.S. bond investors – excluding the Federal Reserve – of more than $1 trillion, or 8 percent of U.S. gross domestic product.

The potential loss of value in government debt as a share of GDP is at a record high for most advanced economies, ranging from about 15 percent to 35 percent in France, Italy, Japan and Britain.

"As foreign and domestic banks would be among those experiencing the losses, interest rate increases pose risks to the stability of the financial system if not executed with great care," the BIS said.”


(emphasis added)

In another recent FT article, the threat to global bank balance sheets is discussed in more detail. We would point out to this that as part of the LTRO-driven rescue of euro-land banks, we always suspected that sub rosa agreements between banks and national governments were made to the effect that banks would employ the generous ECB funding to buy as many government bonds as they could. In return, governments sanctified some of the more dodgy bank assets with 'state guarantees', so they could be pawned off to the ECB without a hitch. Regulations were also quietly tweaked to restore the essentially 'risk free' status of toxic toilet paper as long as it bears the stamp of a sovereign. As a result, banks in places like Spain and Italy are now loaded to the gills with the debt issued by their governments. It was a great trade as long as yields were falling, but now it's not so great anymore. Another few weeks of rising yields and it will be downright dangerous.


“The recovery in global banks' balance sheets is under threat from a surge in bond yields, according to senior bank executives and analysts preparing for quarterly earnings season.

Banks have built giant portfolios of liquid securities, partly at the behest of regulators and also because they have not found better opportunities to lend a flood of deposits. Under new capital rules, unrealized losses in these "available for sale" portfolios hit banks' equity capital.

"I would think most institutions are going to have a fairly sizeable hit to their equity," said a senior executive of a top U.S. bank. "You've really had this concentrated one-to-two week period where all hell is breaking loose."

The composition of the balance sheets leaves banks vulnerable to the spike in interest rates. For example, Bank of America has a $315 billion securities portfolio, 90 percent of which is invested in mortgage-backed securities and Treasurys. As yields rise, prices fall.

In the U.S., the unrealised net gains on "available for sale" portfolios has slumped to $16.7 billion, its lowest level in two years, according to the latest Federal Reserve data. The metric tracks the performance of banks' AFS portfolios, largely comprised of mortgage-backed securities and Treasuries, and the fall represents a drop of more than 50 percent in two months.”


(emphasis added)

A drop of more than 50 percentage points in two months? That's a lot of wood.  The yield on treasuries is slightly lower as well recently, but as a weekly chart shows, the 10-year treasury note yield has broken above a strong lateral resistance level. We would therefore expect that a pullback will probably find support at this level:



TNX-weekly10 year treasury note yield: a spike above lateral resistance – click to enlarge.




The recent 'sudden debt death' has quite a few potential ramifications. If bond prices continue to recover from here, then it was at the very least a very loud warning shot. However, one must also consider what is likely to happen if bond prices fail to recover and the recent rise in yields resumes. In that case, the increase in yields could easily end up as the next crisis trigger. We have already discussed the danger in which Italy would find itself if yields were to increase further. Obviously, Japan's public debt dynamics would also become unsustainable very quickly should the BoJ lose control of JGB yields. Lastly, leveraged players in bond markets and banks all stand to lose monumental amounts of money if bond prices resume their decline.

Just as has happened recently, this would likely lead to forced selling in other markets as well. We're not quite sure why traders seem to think that selling gold is a particularly good idea under these circumstances.  That is one of the mysteries of the current market action. If bond market strains were to worsen, gold would actually represent the perfect hedge; after all, it harbors no counterparty risk.



Download link to the the 83rd BIS annual report



Charts by: Markit, StockCharts




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7 Responses to “Bond Market Losses – A Potential Crisis Trigger?”

  • jimmyjames:

    Lastly, leveraged players in bond markets and banks all stand to lose monumental amounts of money if bond prices resume their decline.


    No worries.. the new “bail in” clauses that have recently and rapidly been introduced around the world should cover any losses that the prestigious few might encounter- i’m sure depositors are more than happy to see their savings stolen for da good of da cauzz-
    Losses do not exist in that world-

  • Monty Capuletti:

    This is going to get REALLY interesting in the next few months….The move in rates threatens to undo:

    A) the US & Global bank health outlook (as mentioned above)
    B) the “wealth effect” of higher stock prices, which (according to the Fed) drives consumption
    C) the emerging markets “growth” story (see EM stock & Bond mkts)
    D) stable inflation outlook (See break-evens)
    E) Perceived Sovereign debt sustainability (umm…Looking at you Japan, & US/W. Europe- how does that deficit get funded w/ int rates 20-50% higher)
    F) the US housing & auto recovery (mortgage rates!!!)

    That’s just for starters…Now that many EM currencies have crashed (looking at you Brazil, India etc..) and the
    QE fallout has been turned on it’s head- weak USD from QE led to EM Central Bank rebukes for “too strong” currencies, the inflationary impact of stronger USD/no QE will lead to another wave of rebukes and likely policy actions (more dollar pegs anyone? Official SDR support? Gold pegs?) More capital controls and taxes are a certainty, as are divisiveness and trade wars…..With so much at stake, I would certainly doubt that those in power (CB’s) will ever leave that much to be determined by markets, in which case, we should indeed expect MUCH more QE- by that name or any other…

  • ab initio:

    The bond market is the most important factor to track right now.

    Although many of the bonds have been falling since early May, the media have been using Helicopter Ben’s potential taper as the raison d’etre. Note that many Fed heads have been walking that back since Ben’s press conference. I doubt sophisticated credit markets really believe that there will be any tapering of central bank balance sheet expansion. But if that was the cause for the sell-off, then we should see the credit markets return to their bull market ways.

    There is a possibility that the bond market has turned it’s tune and that will become more apparent if rising rates cause a significant break in the equity markets. Since, usually that creates the fear trade into government bonds particularly Treasury and Bunds. If however, rates continue to rise then I think we will see some serious blow-ups among the leveraged speculating community. Think LTCM squared.

    Further down that road, we could see highly indebted sovereigns like the Japanese come unglued. The next few weeks are going to be crucial – what happens in the credit markets will impact other assets.

    • Andrew Judd:

      I think we need a bit of a reality check here. James Bullard was talking about tapering last year. Obviously an improving economic situation is going to be bring tapering closer to being a reality and the market will react to it. However current data does not seem to justify the markets enthusiasm so tapering talk seems likely to be pulled back until the data justifies it.

      Until events show otherwise i dont see anything going on to suggest that there is the makings of a crisis here.

      However it has always seemed to me that the bond market pricing was irrational, but i was the sucker who was expecting higher price inflation. At the moment the price inflation pull back could only be a blip which is the feds current assumption. With consumer confidance at a 5 year high and house prices rising quite strongly you would expect people to be spending more money and the fed knows it does not have any magic powers and will have to get on top of expectations of price rises.

      I think you guys tend to over react and want to believe that hyperinflationary doom is much closer than is the case. This situation could last for decades

      • ab initio:

        Who is talking about “hyperinflationary doom”?

        My point is keep focused on the bond market. Since there will be no reduction in any central bank’s balance sheet any time soon it should return to it’s previous placid state. If on the other hand yields continue to rise despite increased money printing then I contend that the bond market is running away. That situation has massive implications for leveraged positions that are interest rate sensitive. Note that in Japan even with Kuroda upping the ante buying $75 billion a month – JGB yields have increased. I am most interested in keeping an eye out for how JGBs trade over the next weeks and months.

      • JasonEmery:

        “I think you guys tend to over react and want to believe that hyperinflationary doom is much closer than is the case. This situation could last for decades.”

        I doubt that. Part of the ‘situation’ is that they [usa] are running a GAAP fiscal deficit of $7 trillion/year. That can last a little while longer, but not multiple years, much less decades.

        You’ve probably heard of Occam’s Razor, which ‘states that among competing hypotheses, the hypothesis with the fewest assumptions should be selected. In other words, the simplest explanation is usually the correct one’.

        If yields are rising, even with the fed buying a trillion dollars worth of them a year, the simplest explanation to me is that interests rates are way too low for the marginal bond buyer. This jives with the $7 trillion annual deficit data. The $7 trillion/yr isn’t pushing up prices because most of it isn’t being spent, but markets tend to look forward.

      • I should perhaps point out, I also think that a hyperinflation event is highly unlikely in the next few years. For instance, I would expect the current Fed to become very careful if its preferred measures of purchasing power (flawed as they are) were to increase significantly, although I do expect the ‘price stability’ dogma to be weakened over time.
        Here comes the but: inflation is a process at first. It only becomes an ‘event’ much later. The decisive point (as the Fed knows very well) are inflation expectations. An inflationary policy can indeed be carried on for many years without obvious untoward effects on CPI (there are of course ALWAYS untoward effects with respect to the intertemporal allocation of resources). At which point the public begins to regard the increase in the supply of money as a threat to price stability cannot be known with certainty. However, if an inflationary policy is just carried on and on without any effort to seriously rein it in, that point WILL one day be reached. There is an unknown threshold once prices begin to rise on a broad basis that I would call the ‘point of no return’. Only then comes the transformation from process to event, i.e., the crack-up boom appears. It is recently happening in Venezuela.

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