If we compare bonds and equities, most of the financial commentators know more about equities.
Equities are the asset class that have higher expected returns, and therefore interest us more.
Bonds do have their fans.
In fact, the higher net worth prefers to hold a larger part of their net worth in fixed income (other than property). Objectively, they think that they do not need to push their money so hard, and lean mainly in the wealth preservation mode.
Another reason is that their private bankers would introduce them to the “safe” way to leverage with bonds. They can borrow more on their principal with bonds and property than with other asset classes.
Their strategy revolves mainly around buying and holding individual bonds on a leveraged basis then rolling over to equivalent yielding bonds.
Aside from that, they are also a fan of the higher-yielding bond unit trust.
No surprise that they can leverage upon these as well.
It would be more difficult to discuss bond investing on a portfolio management basis. We are less familiar maybe because it is difficult to manage on a do-it-yourself basis.
Each bond denomination is 250,000 that even if my net wealth is $1 million, I can only own 4 bonds. In contrast, with $10,000, I can own a diversified equity portfolio if I want.
A month ago, the Rational Reminder podcast invited Dave Plecha to share his experience managing and communicating bond investing.
Dave Plecha has been in Dimensional since 1989 and is currently their Global Head of Fixed Income.
As a member of the Investment Committee and Investment Research Committee, he manages the US and global portfolios, but also maintain the communication and research of fixed income.
In this podcast, Dave tries to deconstruct how he and indirectly, how Dimensional Fund Advisers look at the bond world. (You can read my comprehensive introduction to Dimensional Fund Advisors here)
This podcast may interest those investors who have Dimensional bond funds in their portfolios.
For the longest time, it confounds investors and even advisers how Dimensional manages their bonds. They got the idea that Dimensional’s bond portfolio is not too different from Vanguard’s index bond portfolio.
How different is their implementation versus passive and active managers?
The three bond funds available locally:
- Global Short Fixed Income Fund
- Global Short-term Investment Grade Fixed Income Fund
- Global Core Fixed Income Fund
All funds are available in SGD-hedged class, which addresses the currency fluctuation risk of bond funds.
Currently, Singaporeans can get access to Dimensional bond funds through a few advisory firms that are accredited to recommend Dimensional’s funds. This includes MoneyOwl, Endowus, GYC advisory and also Providend.
But this podcast is more than about Dimensional. I am sure this podcast will be informative for the DIY investor who wonders about their bond allocation as well.
Personally, this is more comprehensible than the stuff I hear directly from Dimensional.
Here are my notes.
How much premium is currently above the risk-free rate?
Premium depends on the change in bond curve shape and change in credit spreads.
Range of premiums above risk-free due to steeper curve:
Intermediate bonds 1.25-1.5%
Cash to 1-year: 0.75%
Cash to 5-year: 1.00% + 0.75%
Range of premiums above risk-free due to credit spread: 0.80% for investment-grade credit in intermediate space.
The Impact of Negative Interest Rate
Currency hedging will equalize short-term rates. This will turn the foreign short-term rate to the domestic short-term rate. This means after currency hedging their rate will look like your home country.
You will only be interested in the foreign bond if the term curve is steeper, the credit rate is wider.
So it is back to premiums again.
For financial planning, you are not concern about nominal rates but real rates.
Nominal rate = 4%, Inflation =5%, you lose 1% purchasing power. Real rates matter more.
Kyith: In a certain sense, Dave is telling us the yield has to be paired with the currency of the bond and looked together.
Who affects the Interest Rate Curve?
Very, very short end, or the overnight rate: The Fed.
They affect how banks lend to each other, or the overnight transactions.
Further out into the curve: Supply and demand by participants (investors, savers)
“If you go back to Greenspan era, he talked about that too. He referred to it as a conundrum. He’s doing all this activity on the overnight rates, trying to intervene in the market, he’s trying to make rates go up and meanwhile, the yield and the ten-year treasury is going down. So just because short-term rates might be doing something doesn’t mean longer-term rates are doing the same thing. Curves can flatten. Curves can steepen. Curves can do everything in between.”
Inflation worries about returns being wiped out by inflation, Inflation-protected securities
Inflation risk in bonds is not new. People look at this period as if it is a new thing but according to Dave, the nominal bond market in every market around the world, they are assessing inflation expectations every minute of every day.
As economic releases get announced, people are reassessing inflation expectations.
When you go buy your bond, you pay your money, your money’s gone, you got to bond, you bought this fixed set of cash flows.
Nominal bondholders bear the risk of unexpected inflation.
That inflation will turn out to be higher than what it was when you expected, but that’s not new to this current era. That’s not new to a low-interest-rate environment or a high-interest rate environment; it’s always there.
Since bondholders are bearing inflation risk, they need the bond to adequately reward them i.e. there should be a good premium over risk-free to bear the risk.
As the market demands a greater premium, the price of your bond may go down. This is the risk of nominal bonds on the secondary market.
Nominal bond vs inflation-protected bond: Inflation-protected bond has a lower expected return. The difference could well be the risk premium that nominal bonds command for bearing that inflation risk.
An investor in a country with no inflation-protected bond is not too worse off than an investor with access to inflation-protected bonds.
They just need to make sure their nominal bonds have a good premium spread over the risk-free rate to compensate for the inflation risk.
From a financial planning perspective, they can vary the duration of bonds in their portfolio.
They can go for shorter duration bonds if they are worried about the inflation part. Shorter duration bonds mature faster and can be reinvested into bonds of higher rates.
Those with longer duration bonds bear the most risk.
Normal environment, longer duration bonds, more returns. Shorter duration, lower returns.
So there is a trade-off.
Risk Premiums in Long Term Bonds Versus Short Term Bonds have different Pace
Longer duration bonds are also more volatile and sensitive to interest rates and inflation changes.
Thus, long-duration bonds have higher average returns than intermediate bonds which have higher average returns than shorter-term bonds.
However, the rate of increase for these different bond classes are not linear.
Premium go up but increasing at a decelerating rate and this leads to all kind of questions.
What Dave means is that the longer duration bonds are more expensive, compensate less for the risk and it seems not correctly priced.
Premiums basically don’t rise at the pace bond risk (volatility) rise.
Why Would Investors Pay for Long-Term Bonds if They Are Always More Expensive? – Asset-Liability Matching
Not all investors look at the market with a mean-variance lens.
A pension fund or insurance company have liabilities that are way out in space in long-duration liabilities that are way out in space in long-duration liabilities.
If the liabilities are nominal in nature and do not need to index to inflation, you may be worried about changes in interest rates because you look at things in present value terms.
In asset-liability matching, you discount these liabilities to present value.
Long term bonds are a nice hedge because you can line up your assets with your liabilities.
If you take the present value of both assets and liabilities, they move together.
Based on the last section, the increasing duration increases your risk, but the insurance company’s risk is different.
In their case, by using long-duration bonds, the risks are reduced because the insurance company is aligning the assets and liabilities.
Dave also mentions that conversely, if the insurance company have long duration liabilities and they went to buy T-bills, treasury bills, which according to mean-variance is safe, this puts the insurance company in a very risky position.
Financial Planning from a Risk Management Perspective
Clients and advisers should ask what are the risk that you are more concerned /sensitive about:
- Volatility: Don’t go too far out into the duration or credit curve. Can just go with intermediate bonds and not super long duration ones.
- Liability: The bonds that match the duration.
- Inflation: Shorter duration
They say long-duration bonds have a lower correlation with stocks, even more negative in a crisis. That means that they are a better diversifier than short duration bonds.
Dimensional studied Ibbotson data going back to the mid’20s’ on long term treasury bonds and the stock market in the US.
Look at rolling 5-year correlation through time for the two assets.
Over these 60 months, the correlations are negative.
But over that period, there were long stretches from e.g. 1930 to the 1950s, correlations between equity and long duration bonds are positive.
Then it dips negative.
Then from the 1960s to 2000 or 35 years, correlations are positive.
Now, it is negative.
Some strategies rely on this negative correlation to work. And if you implement a long duration bond you are taking a big bet.
If we are investing we should be curious about correlations going forward. Correlations are notoriously non-stationary.
Contrasting Equity and Bond Market
Dave thinks the bond market is less complicated than the equity market.
If we get a bond of certain high quality, the probability of default is very, very low, the cash flow is so predictable that we can value it very clearly.
We cannot do that with equity.
Equity markets are more in the news. Bonds are more foreign to people.
Observations of March 2020 COVID
Volumes high. Volatility is extremely high. Bid-ask spread widening out.
Dimensional trading vs BlackRock or Vanguard.
- Flexible approach at the time of the trade.
- Portfolio formation.
- Try to deliver term and credit premium.
There may be a group of bonds that may deliver the term of credit premiums.
Bond strategies can span a spectrum.
- On the Active end: Active very concentrated positions versus the Index. Try to find the best pricing. They will try their best to get that issue.
- On the Passive end: The passive indexer
Dimensional is more like they want to own that issue, similar to the active and very concentrated position, but they are not going to be very forceful. If they cannot get it, they will try and get another with similar characteristics.
“I always tell people that the most powerful position you can put your trader in when you send them out to the market with an order is give them the ability to walk away from any trade. It’s like when you’re buying a house, once you fall in love with the house you’re done, as far as you’re negotiating.”
The indexer holds a very diversified portfolio but they have very, very specific characteristics that they go after because their end goal is to minimize tracking error.
Thus, the indexer is not so flexible at the time of trade and for Dimensional they are very vigilant on their credit transactions cost analysis and is able to get the trade at 10-15 basis points better than their peers in the market.
Factor investing – Difference between Equities and Bonds
The two dominant factors in bonds: Term and Credit.
Dimensional’s research shows that the current price has information on the expected premiums (term and credit)
Dave explains that people like to bring over factors from the equity world. One good example is value.
Before all this, we need to understand that we have been able to calculate the forward rate, which is the proxy for expected return, from the current price.
To see if the value would work in bonds, we have to define what does value mean in the bond world properly.
- In the starting period, there is already an expected return, that is, the forward rate.
- When we get the end of period results, we need to subtract the starting period result.
- What we are left with is the unexpected return.
Dimensional studied a total of 14 factors such as short term equity returns, equity momentum, bond momentum, credit momentum.
They did find that stock momentum can help predict fixed income returns but it is very, very short term. It can be difficult to explain the economic driver or any explanation why that occurs.
They did find some quartile of bonds having poor momentum. The implementation may be to sell those bonds and buy them back later. That might not be the most efficient.
Another implementation that tries to do something similar, maybe just to delay the bond purchase.
As the factor disappears so fast, there is less harm if we miss it out.
Why are Forward Rates (from Fama’s research) so pivotal to the fixed income strategy?
Here is Dave’s simple example to explain this.
Let’s say you have a 2-year horizon and the only bonds you can choose from are 1-year bonds or 2-year zero-coupon bonds.
I could go buy, right now, a 2-year bond and I can know with certainty how much money I’m going to end up with.
Now, my alternative is I could go buy a 1-year bond and I’ll know with certainty how much money I’ll end up with a year from now.
But then after 1 year, I’ll have to go buy a new one-year bond to get to my two-year horizon.
But here’s what I know.
I know how much money I could have with certainty in 2 years, and I know how much money I could have with certainly in 1 year.
So I could solve for, “What does the 1-year rate have to be 1 year from now to make me indifferent between those two?”
So I get, it’s just a simple division there, and that’s a forward rate, the one-year rate starting in one year. So that’s easy math to solve for the forward rate.
Now, for years and years, people would look at that forward rate and they’re asking, “How should I interpret it?”
A lot of people concluded, “Oh, that’s the market expectation for what the 1-year rate will be 1 year from now.”
That’s how the market determined what the rate of 1-year and 2- year bonds ought to look like relative to each other because they’re expecting the one-year rate to be this.
Well, Eugene Fama was among the first to just start doing empirical tests and he found out that forward rates are terrible predictors of the 1-year rate.
Fama found out that a better predictor of the 1-year rate 1 year from now is to use today’s 1-year rate, just use the information price in the current curve.
With this knowledge, we have a third alternative to the previous problem:
I go buy a 2-year bond. I hold it for 1 year. I sell it. I take the proceeds, go buy a new 2-year bond, hold it for a year, and I sell that and now my 2 years is up.
With the way the math works:
The expected return of buying that 2-year bond, hold it for 1 year, sell and knowing that the current 1-year yield as a proxy for 1-year yield a year from now = Forward rate.
Saying the current one-year yield is a better proxy is another way of saying that the forward rate is a better proxy for expected holding period return than it is as a proxy for the future one-year rate.
How do we use what we know about forwarding rates to build better portfolios than cap-weighted bonds?
If we have the same 2-year horizon, which method to choose will depend on the yield curve.
If the curve is upward sloped, and transaction costs are kept low, the highest expected return is going to be a buy-to-sell at 1 strategy and we do it twice.
If the curve is perfectly flat and costs are kept low, all 3 strategies will be the same.
If the curve is downward sloped, the highest expected return is going to buy that 1-year end hold to maturity and do that twice.
Expected returns do not stay constant over time. And our position should change over time.
Dimensional does not hold the bonds to maturity.
They hold it through a segment of the curve, as the curve changes, they are willing to move from one bond to another to improve the expected return.
This is a systematic approach of going after and positioning the portfolio for higher expected returns. They are not forecasting the change in the curve but letting the information in the current curve tell us what to do.
In actual implementation, instead of the example, Dimensional is not just looking at a 2-year horizon but the whole curve.
They are also looking at different curves of different credit quality.
- The universe is 18,000 bonds.
- Calculate the expected returns for a whole array of different holding periods. This way they will know the forward rates.
- With forward rates, which affects the next 1-year return, they can position the portfolio efficiently by holding the bonds based on each of the different curves.
In a Variable Maturity Strategy, is the Expected Premium the same as the Maturity Premium?
The expected premium is a function of the steepness of the curve.
Premiums mean the amount of excess from the risk-free rate.
If the curve is flat, we might not expect any premium. If the curve is inverted, we might expect a lower return for those longer bonds than the shorter duration bonds.
If we are expecting a lower return and if we are also sensitive to volatility (like most investors are), you would not want more volatility and a lower expected return. The decision would be to move to the shorter end of the curve, thereby increasing our expected return and reducing the volatility.
This phenomenon does not mean that the market fails to price assets or that a catastrophe is going to happen.
It simply means the demand for longer bonds is greater than shorter bonds.
Contrasting this to Passive
The passive approach prioritizes ensuring low tracking error.
The shape of the curve does not matter to them.
For Dimensional, the shape of the curve matters a lot because they are trying to maximize or increase the expected return as much as possible, subject to all the constraints Dimensional define for the portfolio.
Why this is not Market-timing
This is a lack of market timing because Dimensional is looking at current prices, looking at the current yield curve and calculating a set of expected returns without forecasting any changes.
They just look at the curve.
And decide which part of the curve they wish to be.
This is based on decades and decades of research.
- People look at an upwardly sloped curve and they say, “Yeah, but I think rates are going up. So there’s no way I’m going to take a net duration out the curve.
- People going to stay short because when they are right in their forecast, rates go up, they will be so glad that they had a short duration relative to their benchmark, and they are going to outperform my benchmark.
- The current curve is offering this and we are going to go with the best alternative of the current curve.
The Difference between Very Active, Very Passive Bond Management and Dimensional
Dave helps us illustrate how managers along with the passive-active spectrum deal with portfolio selection and management.
The very active bond manager is very focused on which bond they wish to buy. They only want specific issues and are less flexible.
The very passive bond manager is very diversified and holds many bonds, but they have very, very specific characteristics that they go after as well. Their goal is to minimize tracking errors.
This means that they cannot be as flexible at a time of the trade.
Dimensional sits in between the active and passive divide.
Compared to the very concentrated bond manager, they can buy a variety of bonds that satisfy the necessary characteristics. This gives them the ability to walk away from unfavourable conditions.
Compared to the index bond manager, they can vary their time of the trade. They do not need to execute immediately.
The Uniqueness of the Bond Universe Allows the Bond Manager to form a Better Portfolio than the Index
With Dimensional’s expected return model, they can calculate the respective return of every bond in their universe.
They can also calculate the expected return of every bond in the benchmark, in the index.
In their expected return model, they treat price as correct. This means that the price factor in the current view of the world is efficient.
Given this current view of the world (all the respective positions of the yield curves, their slopes), they asked themselves: What is the best portfolio they can form right now?
As they know the weights of their portfolio and index, they can know the expected return of their portfolio and the benchmark.
So they can construct a portfolio that is better than the index.
Dave explains that we should not interpret that their expected return will match the actual return. This is a statistical term they are using. This expected return will only be equal to the actual return in the long run.
In the short run, it is highly unlikely the actual return will turn out to be similar to the expected return.
Do we need to be globally diversified for bonds?
It is important to be globally diversified.
What freak out many people is the volatility in the currency. They look at the currency volatility and think it is better to invest in their home currency.
But by investing globally, would allow us to have more bond curves to invest in.
There may be bond curves that are steeper or have credit spread wider than historical.
So the solution is to hedge the currency so that we can form a portfolio filled with less correlated bonds.
If we own a cap-weighted universe bond ETF, do we still get access to premiums?
Yes, we do.
We just get the long-run average term and credit premium.
Compared to the Dimensional approach, the duration is static. The driver of return is less to do with curves, shapes or expected returns but more with composition.
The composition will determine the average credit rating, which drives the credit premium. The term premium is rather fixed.
Dimensional’s approach is more active and the downside is they incur more costs.
But they believe that by varying the term, the credit curves, they can potentially capture higher premiums.
The opportunity for Dimensional to capture greater credit and term premiums versus cap-weighted bond ETF
Ben commented that Dimensional’s dynamic management may allow them to buy bond segments that are more undervalued during periods like COVID-19.
Dave explains that in his dictionary, they view the credit spread above risk-free rate as a barometer of value.
A wider credit spread versus historical may indicate a higher future expected return if the bond does not default.
There is a connection between today’s observable credit spreads and future realized premiums.
When the credit spreads are wide, on average, we do capture higher credit premiums.
So Dimensional can position their portfolios by allocating to bonds with higher expected returns better than cap-weighted bond ETF.
However, they do have limits of the amount of BBB, single A or AA that they can tilt towards for each of their funds.
Investors need to ask themselves whether they wish to be more static or dynamic.
Kyith: For those of you who have invested in Dimensional’s bond funds, my understanding is that Global Short Fixed Income and Global Short-Term Investment Grade Fixed Income Fund is more limited to how far they can be tilted. Global Core Fixed Income fund has relatively more leeway to tilt and over-allocate.
Ben commented that Dave document in his variable maturity, variable credit approach to fixed income. He asked if it is feasible for the DIY investors to build a strategy documented in his paper.
Dave says they could try but it will be a full-time job.
They will have to keep track of the US Treasury curve, the agency curve, the AAA curve, the AA curve, the single-A curve, BBB and BB. They may also want to keep track of 11 other curves.
They have to do it every day to sense.
Then, they have to implement this at a low cost.
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