Stocks are a risky investment. Every investor knows it. That is why experts advise to hold a diversified portfolio including bonds.
Bonds provide income and security, in theory. But with rates at historically low levels, bond risk has hit an all-time high.
One of the simplest measures of bond risk is the Sherman Ratio. This little-known metric shows how much interest rates must rise to destroy a year of income.
With rates falling last year, the Sherman ratio for investment grade corporate bonds stands at 0.20. This is the lowest reading since 1997, and lower values are riskier than higher values.
Sherman ratio shows high risk for bonds
If rates rise by a quarter of a point, more than $ 7 trillion could be destroyed
This graph shows that companies behave rationally. As rates fell, they issued bonds with more time to run. This reflects the behavior of many consumers who have blocked 30-year mortgages at low rates.
But, based on the Sherman Ratio, it is possible to argue that investors behave irrationally. They take more and more risks for less and less income.
The current rate trend indicates that these irrational buyers could suffer more.
Yields on 10-year treasury bills recently exceeded 1.1%, more than double the August low of 0.52%. Corporate bonds tend to move in the same direction as treasury bills, and corporate yields have increased over the same period.
The rate hike has cost investors dearly. As rates rise, bond prices fall. This relationship exists because once the bonds are issued, they trade in the secondary market, providing liquidity to investors who might not want to hold the bonds to maturity. But it does mean that old bonds must be priced competitively with newly issued bonds.
If new bonds are issued at higher rates, the old bonds must fall in price so that investors can pay less and receive an amount of income equivalent to the new bonds.
According to Bloomberg, with the Sherman ratio at 0.2, investors will lose $ 6.75 trillion when rates rise 0.2%.
A quarter point move by the Federal Reserve would destroy over $ 7 trillion in corporate bond wealth and trillions more in the treasury market. These losses could trigger a sell off of stocks, destroying billions of more wealth.
The Fed does not want to panic and it is unlikely to act soon. But rates may rise further as traders worry about inflation in the face of the Fed’s inaction.
Michael carris an authorized market technician forBanyan hillPublishing and the publisher ofA shop,Peak Velocity TraderandPrecision Profits. He teaches technical analysis and quantitative technical analysis at the New York Institute of Finance. Mr. Carr is also the former editor of the CMT Association newsletter,Technically speaking.
Follow him on twitter@MichaelCarrGuru.