You don’t know as much about bonds as you think you do

You don’t know as much about bonds as you think you do

By Allan Sloan, senior editor-at-large July 25, 2013: 5:00 AM ET

Don’t feel bad if you weren’t aware of the recent plummet in long-term bond prices. Most everyone else missed it too.

FORTUNE — We hear lots of talk about the bond market these days. So let me ask you a simple question: Do you think you’d notice if a key bond-market segment took a one-day hit equivalent to a 600-point drop in the Dow? Answer: No, you wouldn’t. How do I know that? Because when such a drop took place recently, almost no one outside of a few bond experts noticed.Here’s the deal. On July 5 the market price of 30-year Treasury bonds fell about 4.1% — the equivalent of a 615-point drop in the Dow, which at the time was around 15,000. That’s a really serious drop, folks. If you owned $10,000 of 30-year Treasuries due in November 2042, for example, your investment would have declined in value by $354, exceeding the $275 of annual interest the bond pays. So you lost more than a year’s interest in one day. Pretty scary.

When last I looked, the bond was trading at about 83.9% of face value, which means that holders had lost almost six years’ worth of interest in the eight months since the bond was issued. Collectively, holders of this issue, which has a face value of $16 billion, have lost more than $2.5 billion. To use the technical term: Yechhh! Don’t feel bad if you didn’t know about this hideous drop — few people do. That’s because although the Dow (INDU) and Standard & Poor’s 500 (SPX), which track the stock market, have huge public recognition, there’s nothing equivalent for bonds. So bonds can fall — or rise — sharply, with few people other than bond mavens realizing it.

In fact, long-term bond prices have been falling for about a year. Consult a Bloomberg terminal (whence my price numbers come), and you see that the price of a generic 30-year Treasury bond peaked on July 25, 2012. Since then, the Dow and S&P have risen 23% and 26%, respectively, setting one new high after another. So we’ve had a big, endlessly discussed bull market in stocks at the same time we’ve had a far-less-noticed yearlong bear market in bonds, with the 30-year Treasury yield rising to about 3.65% from a low of 2.25%.

This bond bear market has come despite the Federal Reserve’s having bought about $1 trillion — that’s trillion, with a “t” — of bonds over the past 12 months in an attempt to keep bond prices high (and interest rates low) in the name of providing economic stimulus.

Shorter rates, which the Fed controls directly, are still down in near-zero land — and are actually somewhat lower than they were when the bond market peaked a year ago. But this hasn’t kept long-term rates from rising, albeit in a choppy way rather than straight up.

The rise accelerated when Fed chairman Ben Bernanke — apparently without realizing the impact he would have on the financial markets — said in late May that the Fed might soon begin “tapering” its bond purchases. Bernanke’s clueless remark accelerated the drop in bond prices — but it had already been under way for 10 months.

It would be very easy — but overly simplistic —  to say that long-term rates will soar to the stratosphere and stay there once the Fed stops buying bonds, and when it starts raising short-term rates.

But life isn’t quite that simple. Sure, I expect long-term rates, which despite their recent rise are still quite low by historical standards, to rise another point or two. And I expect some bondholders to freak out and dump their holdings when the Fed finally raises short-term rates. However, the Fed’s raising short rates could well beget a stabilization —  or even, after a while, a decline —  in long rates. That happened in 1995 and again in 2000, presumably because bond investors began to think that the Fed was serious about holding down inflation. Inflation, as they teach in Investing 101, erodes the value of long-term bonds, and less inflation is better for long bonds than more inflation is.

Ah, the irony: The Fed could end up lowering rates that it doesn’t control by raising rates that it does control. Yet another example of how the bond market works in mysterious ways.