I must confess, for a lot of my career, I looked down on bond managers. I mean:

With their defined redemption terms and regular coupon payments, bonds just don’t move around as much as equities. Their value is anchored. As a result, bond funds tend to generate steadier returns than equity funds and managing them may not be as…hard? ¹

This year, though, they haven’t behaved according to script. The flagship benchmark of US bond market performance, the Bloomberg US Aggregate Bond Index, is down 17% since the beginning of January and the largest actively managed bond fund, Pimco’s Total Return Fund, is down 22%. Granted, these numbers are less than an equity fund can lose in a month, but they reflect an unprecedented drawdown. The index last went negative on a rolling 12 month basis in 2018 and before that in 2013, but to have sustained losses greater than 2.5% you’ve got to go all the way back to 1981 and to 1994. 

For many of today’s investors, though, those episodes are ancient history, memories of them crowded out by a long period of low rates and low volatility. Two weeks ago, we looked at the increased frequency of margin calls as a feature of the current market environment. Today, we look back at these prior episodes of bond market stress to see what lessons can be drawn from how managers navigated them. Spoiler: it’s all about leverage. 

1981

Back in 1981, the bond market was a lot smaller. Today, the value of US bonds outstanding is $53 trillion, equivalent to around 220% of gross domestic product but back then it was only $2 trillion, or around 67% of GDP. In those days, investors would typically hold on to bonds until maturity, so the amount of trading activity was also very low.

One firm was at the forefront of a new strategy. Pimco had been founded ten years earlier around a strategy to trade bonds more actively. Its founder, Bill Gross, was a financial analyst in the fixed income department at Pacific Mutual Life Insurance Company. One of his jobs was manually to clip the coupons off bond certificates stored in the company’s vault and mail them in for interest payments. Suspecting returns could be enhanced by selling as well as buying bonds, he persuaded his employers to carve out a fund for him to manage. They handed him $5 million from their $1 billion bond portfolio and, together with a small team, Gross set to work.

His first year wasn’t particularly good – the fund lost money. But performance soon picked up. In the years following the recession in 1974, the fund did particularly well and Pimco began to attract interest from external clients, including AT&T and RJ Reynolds Tobacco. 

As the firm entered its second decade, interest rate volatility picked up, making the fund more difficult to manage. In response to high rates of inflation, the Federal Reserve began hiking rates sharply in October 1979, sparking a short recession. In the first three months of 1980, bond markets fell by 9%. After that, rates began to fall but, with inflation still rampant, the Fed had to move again. This time, its tightening prompted a more severe recession and bond markets slid during the first six months of 1981. 

Bill Gross characterises the job of bond manager as “one-third mathematician, one-third economist and one-third horse trader”. In 1981, the economist part of his role came to the fore as Gross anticipated the end of the recession. “Yields turned down in September almost exactly as we called for,” he recounted years later. At the time, he wasn’t managing much money – less than $15 billion of pension money. But his call earned him acclaim. 

While Gross may have navigated the turmoil of 1981 successfully, other investors fared less well. George Soros launched his Quantum hedge fund a couple of years before Pimco was founded, initially to invest in stocks. As macroeconomic conditions became more unstable, he increasingly ventured into bonds and currencies. Over his first 11 years in business, through to the end of 1980, Soros’ fund compounded at an annual rate of 38% and fund assets grew to $381 million. 

But 1981 was a “debacle” (his words). Coincident with a profile in Institutional Investor magazine heralding him as “the world’s greatest money manager”, his fund suffered its first ever down year, losing 23%. Soros was hit by a wave of redemptions and assets in the fund shrank to $193 million. The episode so impacted him that in September he stepped away from markets, entrusting his money to others to manage. Recognising that “macroeconomic speculation has become paramount,” he came back in 1984 with a new strategy, laid out in his book, The Alchemy of Finance. 

1994

By 1994, bond markets were much bigger, almost five times the size they were in 1981. At the beginning of the year, the Federal Reserve rate-setting committee met to discuss the economy, concluding that a buildup in inflationary pressures were a cause for concern. Led by Alan Greenspan, policy makers that February raised the benchmark rate for the first time in five years, moving by 25 basis points. Over the following 12 months, they raised rates a further six times, hiking the Federal Funds rate from 3% to 6%. 

For bond investors, it was a shock. On some estimates, capital losses in world bond markets may have been in the region of $1.5 trillion, equivalent to almost 10% of OECD countries’ gross domestic product. 

Pimco suffered. Its Total Return Fund had been launched in 1987, and this was its first test. Between October 1993 and the end of 1994, it was down 14%, against an index that was down 3% over that period. Part of the reason was leverage. 

Since the 1980s, Pimco had embraced derivatives as a tool to enhance returns. Because derivatives don’t involve buying the underlying asset they reference immediately, they require much less cash up front. Pimco could use derivatives to establish the bond exposure it targeted, and invest the cash it saved in other yielding instruments to boost its total return. At a meeting in the early 1990s, Pimco’s investment committee discussed how to account for the structure. Mary Childs picks up the story in her book, The Bond King:

Sitting on the trade floor in the early 1990s, Brynjo [trader John Brynjolfsson] explained this accounting system to the members of the Investment Committee. “… So, we’ll just call that leverage,” he concluded.

Every face went white(r). “That’s not going to work,” one of them said.

“You want me to change the formula?” Brynjo asked.

“No. No, the formula is fine. It’s the name.”

“Well, what else are we going to name it?”

Leverage, borrowing money, can amplify returns because you can invest more, which is great in good times. But leverage only ups the stakes; it can also help you blow up spectacularly. The cocaine of investing, leverage adds juice, but the price for using it might be higher than you can pay. That’s why its use is restricted in funds meant for pensioners, who cannot afford to lose all their money. Even using the word leverage can make conservative managers of mutual and pension funds nervous.

Brynjo cast around in his mind. Leverage … Finance loves the Greek alphabet, and Brynjo was vaguely familiar with it. “What about ‘Lambda Cash’?” Because Lambda also started with an L. 

The Investment Committee approved.

One of the reasons investor losses were so high compared with those in 1981, when the moves in underlying bond prices were actually more violent, is leverage. Fuelled by years of low rates, investors had attached more leverage to their portfolios than in the prior cycle. In Pimco’s case, leverage was quite low – according to Childs, “Lambda Cash” added between 0.25% and 0.40% a year to returns. Other investors were a lot more aggressive.

Like George Soros, hedge fund manager Michael Steinhardt had moved away from trading stocks into trading bonds and commodities as well. At the beginning of 1994, he put on a large position in Canadian bonds, adding to trades he already had on in Japan and Europe. In total, his bond positions amounted to $30 billion. When the Fed hiked rates in February, Steinhardt initially remained unphased. While he did have some positions in US bonds, they were small relative to his international exposures.

But contagion soon took hold across global bond markets as investors began to deleverage and sell assets wherever they could find liquidity. Yields in Europe and Japan spiked upwards. So large and leveraged was his portfolio that for every single basis point rise in European bond yields, Steinhardt was on the hook to lose $10 million. By the end of the month, he had sustained $900 million in losses, down almost 20%. Complicating matters, liquidity was now beginning to seize up as buyers evaporated and prices cratered further. 

“We were losing money and I couldn’t quite catch my breath,” Steinhardt later told author Sebastian Mallaby who writes about the episode in his book, More Money Than God. “Things were happening and we had positions and it was as if I just didn’t quite have the ability to understand where we were and why we were where we were. It was as if we were playing yesterday’s or last year’s game.”

Seeing no way out, Steinhardt directed his traders to dump his bonds at any price. Over a four-day spree in early March, they sold $1 billion worth of European bonds. By the end of the month, the fund had lost $1.3 billion, down 30%. “The trade in European bonds was crowded, a fact that totally passed me by,” confessed Steinhardt afterwards. 

At least he lived to fight another day. The following year, Steinhardt recouped around half of his losses, returning 27% in his fund. He quit not long after, on his own terms. Another hedge fund didn’t quite have that good fortune. 

Askin Capital Management was founded in 1993 by David Askin, a former head of mortgage research at a Wall Street firm. Askin invested in mortgage securities, building up a $2.5 billion portfolio. But the structure of his portfolio made it highly interest rate sensitive in ways Askin did not envisage. He pitched his portfolio as “market neutral” yet for any given rise in long-term interest rates, his portfolio would fall five times more than an ordinary bond. When the Fed began hiking, the fund rapidly lost money. In February alone, it fell by 20% and as conditions deteriorated in March, Askin was faced with an increasing barrage of margin calls. The fund ultimately imploded, leaving its three main brokers with $500 million of losses between them. 

At a Congressional hearing to discuss the fund’s implosion and the broader role hedge funds play in the market, George Soros was called to testify. He conceded that leverage can be destabilising for markets, but if restrictions are to be imposed, they should be applied not just to hedge funds but to a range of financial institutions including brokerage firms. Policy makers didn’t take heed and leverage continued to accumulate. 

Today

Bill Gross is no longer managing Pimco’s bond funds, having walked out of the firm he founded in 2014. But in a blog post this week he bemoans the direction his Total Return fund has taken, arguing that Pimco replaced the fund’s “total return” mandate with an index-hugging one. Yet among his criticisms he does concede that for most of the fund’s life, “a secular bond bull market was a huge tailwind”. And it’s easier to use a “host of other non-index strategies” to bolster returns when you have that tailwind behind you.

Mary Childs says that an insider at Pimco told her Gross only ever really employed four strategies: “There are only four things you need to know. Going long duration, rolling down the [Treasury] curve [i.e., capitalizing on a bond’s price rising as it ticks closer to maturity], going long credit, and going short vol.”

Going short vol is the flipside of going long leverage, and that may not be as profitable a strategy in the current environment. However, after the shakeout, bond returns may begin to look attractive again. As the biggest bond manager in the world, BlackRock clearly has a vested interest. The firm manages $2.35 trillion of bond money. But its President, Rob Kapito may have a point:

If we go back in 1995, to get a 7.5% yield, which is what many institutions were looking for, a portfolio could be in 100% bonds. If you fast forward 10 years, in 2005, it had to be 50% bonds, 40% equities, and 10% alternatives. Then move another 10 years, and in 2016, you needed only 15% bonds, 60% equities and 25% alternatives… Now today, to get that same 7.5% yield, a portfolio could be in 85% bonds and then 15% equities and alternatives.

So far this cycle, outflows from bond funds have been tracking close to the 1994 experience. Back then, flows eventually returned, as they will again. You just have to stay in the game to see it.

Paid subscribers can read on to see how banks are managing their bond portfolios. With securities holdings of $5.7 trillion, they are some of the biggest bond investors in the market. Their portfolios swelled over the past few years; now they have to navigate a difficult market. Will they cope?...