Sunday, January 4, 2009

How Bad Was the 1994 Bond Market Crash?

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To get a feel for what a bond market crash looks like and how it inflicts pain upon bond investors, it's useful to examine the fall-out from 1994. The bond market crash of 2009 will occur for reasons that differ somewhat from the events of 1994, but the consequences will be similar.

Just as a stock market crash tends to hurt certain sectors and certain individual stocks more than others, so, too, does a bond market crash inflict varying amounts of pain on different bond investors. A Treasury Bill investor, where maturities never exceed one year, will not endure the losses incurred by a Treasury Note or a Treasury bond investor, with maturities of ten to thirty years, when interest rates rise. And the most acute pain will be felt by Treasury STRIP investors, where the lack of coupon interest serves to make these instruments a highly leveraged bet on interest rates. When rates go down like they did last year, Treasury STRIP investors can make a lot of money.

But when rates turn back up, STRIP's investors get killed.

There's a great, old article I found this weekend that discusses the trying times of 1994:

THE GREAT BOND MARKET MASSACRE

At the beginning of 1994, the yield on the 30-Year Treasury Bond was around 6 1/4%. By October, it was flirting with 8%, a nearly 175 basis point rise. (In the bond world, one "basis point" is 0.01%.)

A 175 basis point rise from a much lower yield, the 30-Year T-Bond closed with a yield of 2.815% on Friday, is much more destructive to bonds with longer maturities. If long-term yields break 4% this year, the pain will be far worse than what bond investors experienced in 1994.

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