People could lose $3.8 trillion when the bond market gets back to normal

Arnd Wiegmann/Reuters

There's been a lot of concern over the bond market recently.

Historically low yields in the US and over $11 trillion in negative-yielding bonds abroad have some economists, analysts, and income-focused investors sweating.

The desire for yields to pick up, however, may have an unintended consequence, according to Robert Grossman at the credit rating agency Fitch Ratings.

"This year's dramatic fall in yields on bonds issued by investment grade sovereigns has again raised the risk that a sudden interest rate rise could impose large market losses on fixed-income investors around the world," Grossman and his team wrote in a note on Tuesday.

"A hypothetical rapid reversion of rates to 2011 levels for $37.7 trillion worth of investment-grade sovereign bonds could drive market losses of as much as $3.8 trillion, according to our analysis."

The price of bonds decrease as the yield goes up. The idea here, then, is that if the yield of these sovereign bonds increases dramatically, those that trade bonds would see the price of these bonds decrease dramatically.

Bond yields are well below their average in 2011, so a sudden jump back to normal, or at least to historical averages, would be a massive leap.

"Global composite yield curves, derived by Fitch from median yields of the 34 IG-rated countries (with at least $50 billion of outstanding debt) in July 2016 and July 2011, fell across all maturities over the past five years," Grossman wrote.

"Median yields on 10-year securities are 270 basis points lower than they were in July 2011. At the shorter end of the curve, median yields on 1-year securities have fallen by 176 [basis points]."

Grossman and the Fitch team modeled the effect of a jump in yield on the price of bonds from 34 countries. It would hit eurozone bond investors the most, with the jump from negative yields to heightened yields having a devastating effect. UK-based investors would also experience serious pain.

As always, there are a few caveats here, which even the Fitch team acknowledges.

"The pace of any potential global rate shock would be important," Grossman wrote. "A more gradual rate rise, perhaps driven by a slow tightening of monetary conditions worldwide, would result in far less significant market losses for investors."

Basically, it may be good for yields to go up as long as it happens slowly.

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