I have not seen bond yields this low before. As we entered 2021, the 10-year US government bond yields have recovered to 1.11%.
Recovery in bond yields may be an indication of a recovery in the economy. This bodes well for equity markets.
One o fthe question in my head will be how would bonds do this year?
I am less clear how things will be like going forward. Back in 2010, there were enough commentary that the yield is at a very low point. Investors should favor investing in equities as opposed to bonds.
Well, bonds still do rather well as interest rate still went down for 10 years (albeit with volatility during the period)!
A few research show that the future returns of bonds have a strong correlation with current yields. If yields are at 1% or less, why bother invest in them at all?
I am more curious how next year unfolds:
- If bond yields go down even further, bonds will still earn a positive and good total return?
- If bond yields go up, how much damage would this do to bond funds?
- If bond yields languish at current level, how would the highest quality bond fund return? (I have to put high quality because if you go down the credit quality, you could possibly be invested in bonds that earn a higher return)
Question #3 is the question on my mind.
I went through some of the bond data, and I thought there was a period in history that can help us understand bond behaviour when rates were more volatile.
Specifically, I was curious to see how some of these bond index funds today would die if they exist during a period where interest rates had huge fluctuations.
A bond index is a proxy to see the health and performance of a basket of bonds. Today, you can invest in portfolio that tracks a bond index through exchange-traded funds such as the ABF Bond Fund (A35) in Singapore or the iShares Core Global Aggregate Bond UCITS ETF (AGGU) listed on the London Stock Exchange.
So here is my research.
Peering into the Volatile Period of the Early 1980s
There was a period in the late 1970s and early 1980s where the interest rates were very volatile.
I wish to take a look at how your bond unit trust or exchange -traded fund (ETF) would do in such an environment.
During Sep 1979 to 1981, the United States have some of the most violent interest rate volatility.
11.4% rose to 17.6% in 8 months.
8 months is a long period to live through in human life. You would be wondering if you should sell all your REITs and dump into gold.
Then, the rates plunge from 17.5% to 9% in 5-6 months.
Just when you are thinking whether you should load up on bond funds, individual bonds, REITs, the interest rate rise rose more than 100% from 9% to 19.1%.
Rates are just…. very voltile back then.
I have plotted the Bloomberg Barclays US Treasury Bond Index next to the interest rate. I like to use the treasury bond in this first illustration because the U.S bonds should be untainted by questionable credit quality, or country-specific bond risk.
You would be able to observe the inverse relationship between interest rates and existing bond returns. When interest rate goes up, bond returns go down and vice-versa.
However, in real life, the relationship is not that straight forward.
When the rates rise in the initial years, the bond index lost 7% of its value. When the rates go back up, the bond index gain 16% to reach a high of $1.08 in Jun 1980.
However, when the rates subsequently climbed to 19.1%, the bonds do lose value but in less magnitude.
It just goes to show that the negative correlation is not exact.
What if You Hold a Bond Fund of Longer or Shorter Average Maturity?
If the average maturity of your bond fund is longer, do expect the value of your investments to be more volatile.
I take the Bloomberg Barclays US Treasury Bond Index, and introduce US bond and treasury indexes of different duration, over the same period:
This chart shows the growth of $1 from Sep 1979 to Dec 1982.
The duration of the bonds are as follows:
- Shortest: One-Month US Treasury Bills
- Shorter: U.S Treasury Bond Index Intermediate
- Medium: U.S Treasury Bond Index
- Long: U.S Treasury Bond Index Long
The one-month Treasury bill has no opportunity cost. A possible fund like this is like your savings account, which will just capture whatever interest rate is given. And the interest rate back then was damn high.
The U.S bond index and intermediate bond index took 7 months to return to breakeven.
The Long bond took 9 months to recover to break even, before dipping again. In total, it took 32 months or more than 2.6 years before it returns to break even.
If the average duration of your bonds are longer, be prepared for greater volatility.
Here are the deepest draw down for all four:
- One-Month US Treasury Bills: 0%
- U.S Treasury Bond Index Intermediate: 3%
- U.S Treasury Bond Index: 7%
- U.S Treasury Bond Index Long: 19%
Expect some potentially large drawdown if you choose a longer duration bond fund.
I am not asking you to stay away from them because of the drawdown. In certain strategies, you might want a bond fund that is very sensitive to interest rate.
If that is what you are trying to accomplish then a long duration bond fund might work out.
What if You Hold a Bond Fund focus on Corporate Bonds?
In order to get higher return, investors would go out further into the risk spectrum to find bonds with higher interest.
Corporate and credit bond’s quality is lower than U.S Treasury bond, so they should command a premium for the credit quality risk you undertake.
In the chart above, I introduced an intermediate term corporate bond index and long duration credit bond index.
Observe that both their performance are weaker.
While the returns are higher, the draw down may be greater.
View Your Returns Not Just by Yield but Total Returns
In my course of work and interacting with people, I find many judge the return of a bond fund based on the average yield to maturity.
In the long term, the returns have a strong correlation to the current market yield.
However, there are some actions the manager can do to squeeze out some more returns. This can be
- Identifying mispricing in different bond segments
- Shift the bond allocation between longer and shorter duration, higher and lower credit quality, shifting to invest in bonds in different geographical regions
The tough but correct way to review your returns is to compare the bond funds against other assets, other funds based on total return.
This is tough because investors who have experiences with individual bonds, tend to forgo capital appreciation and judge their bonds based on the interest coupon.
This would require some cognitive shift.
The Magnitude of the Bond Volatility Maybe Higher Today Than in the Past
I used a period where the interest rate environment is unlike what we have today.
While I did say the interest rate volatility was high, I think in our climate today, the volatility could be higher.
For example, a 9.1% to 19% move is a 108% change. In today’s climate, a similar move would just be a 1.1% change to 2.28%.
I suspect a move to 2.5% could be a shitty situation for bonds.
But then again, in the past 6 months, the 10-year US treasury yield have shifted from 0.53% to 1.12% today. That was a 111% move.
So what do I know.
I think the rate of change is more important than the magnitude. What the market do not like are surprises and if the participants find it difficult to judge the rate movement, it breeds uncertainty, and usually, that results in greater volatility.
Conclusion – What You Should Focus On
Depending on how you look at things, this morning’s piece may scare the shit out of you to sell all your bonds.
On the other hand, some might feel more assured that things are not so bad.
I should warn everyone that this case study is only one sample. Markets are interesting in that you can have similar situations where interest rates rise and fall but the bond market behaves differently.
In the eyes of an equities investor, a 10% fall may look small but this is a greater than 1 standard deviation event. It is uncommon enough. Given the magnitude of the volatility in bond rates, I actually thought the bond index performance was not too bad.
That is if you have chosen to invest in a bond ETF or unit trust with a shorter duration. This may be a warning for some who has reached for higher yields by going with an ETF with a longer average duration.
I have said a lot of things today but to help you, here are some takeaways to focus on:
- During that period, the longest drawdown was 2.6 to 2.8 years. This is still shorter than some of the terrible equity drawdown periods.
- What kills us are the difference between expectation and reality. Some investors invested in high yield bonds thinking they are similar to government bonds. What will kill them is this gap between expectation and reality. If you do not know the nature of the bond unit trust, ETF or funds in ILP you have invested, the first step is to get educated.
- Understand what kind of role the bonds or bond fund plays in your portfolio or strategy. Most well-meaning advisers advise you to allocate bonds to act as a dampener to reduce your portfolio’s volatility. The returns will come from equities. If you understand this, then remember to review your ENTIRE portfolio’s returns and not just lament at the poor performance of your bond funds!
- If you have bond ETF or funds that did spectacularly well when your equities are doing very well as well, there is a high probability the bond mix in the funds may not be geared to protect your portfolio on the downside when you most need it (read March 2020). Of course, there are periods where both bonds and equity does well. But if your bond fund is doing high returns (close to equity), they are either loaded with lower credit quality, bonds from stranger lands, longer duration. They are basically closer to equities in the risk spectrum
- There are strategies out there that play on the low correlation of bonds and something else. I have no advice on this, but in a way, you might need a longer duration bond fund to capture the returns should the market suddenly change. The magic here might be to frequently rebalance between two highly volatile, and highly uncorrelated asset class.
- If you are a speculator and guard against a sudden rise in rates, you still need to invest in bonds and go for higher quality and shorter duration bonds. Find the sweet spot between capturing enough credit and term premium.
- At some point, in order to earn a higher income, we have to bear the pain so that rates will rise. The bonds in the portfolio need to be held so that the fund does not lose capital. The mark-to-market mechanism may mean based on your total return, the fund looks very lousy. But as the bonds mature, and get rotated into bonds with higher interest, the longer-term returns might be better.
Here are some related articles I have written about bonds in the past:
- Will you lose money on a bond ETF in a rising interest rate environment?
- What We Can Learn About The Bond-like Nature of REITs and Interest Rate Sensitivity During this Market Rout?
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