Post-Mortem on a Bad Year for Bond Investing

How bad was 1999 for bonds?

OK, I wrote that question. Couldn't resist. It's the perfect topic for the first Fixed-Income Forum of the new year.

As you probably already know, 1999 was a terrible year to be a bond investor.

Some types of bonds fared much worse than others. But for most bonds, it was the worst year since 1994, when the Fed raised the fed funds rate a total of 250 basis points.

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That year, the Lehman Aggregate Index, a broad measure of the taxable (as opposed to municipal) bond market, had a total return of minus 2.92% -- its worst year ever. Last year, its second-worst ever, the index lost 0.82%.

But for the one bond that's more familiar than any other to most investors -- the 30-year Treasury bond -- it was the worst year ever. (Or at least since the Treasury resumed issuing the so-called long bond in 1977.) The long bond's total return was minus 14.76%. In 1994, now its second-worst year, it lost 11.99%.

Here, courtesy of Jim Bianco, president of Bianco Research in Barrington, Ill., is a table summarizing the carnage. As you can see, 1999 was also the worst year ever for municipal bonds.

A Bad Year for Bonds 1999 was either the worst year or the second-worst year for many types of bonds
Issue/Index	1999 performance	How 1999 ranks	1994 performance	How 1994 ranks
30-Year Treasury	-14.76%	1	-11.99%	2
2-Year Treasury	1.69	2	0.53	1
Ryan Strips	-12.70	1	-12.60	2
Lehman Aggregate	-0.82	2	-2.92	1
Lehman Government	-2.23	2	-3.37	1
Lehman Mortgage	1.86	5	-1.61	1
Lehman Corporate*	-1.96	4	-3.93	2
Merrill High Yield**	1.57	3	-1.17	2
Merrill Municipal	-6.34	1	-6.18	2
*Worst year ever 1974, -5.86%. **Worst year ever 1990, -4.35%. Source: Bianco Research, Merrill Lynch.

I thought it might be helpful to explain why the table looks the way it does.

Why, for example, was 1999 the worst year ever for the long bond and for Treasury Strips, or zero-coupon bonds, but not for short-maturity Treasuries?

The Fed is the reason why short-maturity Treasuries (represented by the two-year note) didn't have as bad a year in 1999 as in 1994. The yields of short-maturity Treasuries, like all Treasury yields, are set by the market, but they stay closer to the fed funds rate than the yields of longer-maturity instruments do. Over 1994, the Fed hiked the fed funds rate six times, from 3% to 5.5%, a total of 250 basis points. Over the same period, the two-year Treasury's yield rose 338 basis points, from 4.21% to 7.59%.

Last year, the Fed wasn't nearly so aggressive. It hiked rates three times, from 4.75% to 5.5%, a total of 75 basis points. Over the year, the two-year note's yield rose 159 basis points, from 4.51% to 6.10%. The smaller increase in yields was less damaging to the price of the short-term securities, and thus to their total return.

The reason why the long bond had its worst year ever last year is somewhat more complicated.

Because after all, the long bond's yield rose less last year than it did in 1994. Last year, the 30-year Treasury's yield rose 129 basis points, from 5.06% to 6.35%. In 1994, it rose 162 basis points, from 6.25% to 7.87%.

But there's no real mystery here. The simple fact is that a 129-basis-point rise in yields does more damage to the price of a bond when its yield starts out at a mere 5% than a 162-basis-point rise does when the yield starts out at a loftier 6.25%. Think of it as a larger percentage gain in the yield.

The same principle explains why Treasury Strips suffered a worse fate last year than in 1994: Their yields rose by larger proportional amounts.

Short-term Treasuries helped the Lehman Aggregate Index avoid a loss bigger than the one it incurred in 1994. But so did so-called spread product -- bonds issued by federal agencies such as Fannie Mae (FNM) and Freddie Mac (FRE); mortgage-pool aggregators such as Fannie, Freddie and Ginnie Mae, the Government National Mortgage Association; and corporations, both investment-grade and high-yield.

It's called spread product because the yields of these types of securities are evaluated not on an absolute basis, but on the basis of their "spread to Treasuries." In other words, traders and investors focus on how much higher a corporate bond's yield is than the yield of a Treasury of comparable maturity, for example.

Agency, mortgage-backed, investment-grade corporate and high-yield corporate bonds performed better in 1999 than in 1994 in large part because of the fate they suffered in 1998.

Spread product got uniformly trashed at the end of 1998 in the madness that ensued after Russia defaulted on its debt. As investors demanded safety and liquidity at any price, Treasury securities rocketed in price, and all other bonds tumbled, blowing spreads out to recessionary levels.

Last year was no picnic for the spread-product markets. Issuance surged during the first half of the year as corporate issuers in particular accelerated their financing plans in order not to have to issue bonds during the second half of the year, when they presumed investors would have Y2K on the brain and not want to buy risky bonds. Spreads widened nearly as much, in some cases, as they had in the fall of 1998. But at the end of the day, Robert W. Baird senior bond strategist Jim Kochan explains, "spread product started the year very cheap, and ended the year not quite as cheap."

As for municipal bonds, they did worse in 1999 than in 1994 because their yields not only started 1999 at a lower point than they started 1994, but they rose more in 1999 than in 1994. The yield of the Merrill Municipal Master Index rose 123 basis points in 1999, from 4.83% to 6.06%. In 1994, the index's yield rose 119 basis points, from 5.32% to 6.51%.

Munis' poor performance in 1999 was due at least in part to the fact that institutional investors who normally buy them opted to buy spread product instead, in order to take advantage of corporate yields that were inflated by a supply glut, says Dave MacEwen, senior portfolio manager at American Century.

Next week: How bad was 1999 for bond funds?

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