Live and Let Buy: Which Bonds For Your Objectives?
The Definitive Guide to Bond Index Investing - PART 2
Welcome to Part 2 of Licence to Yield – Our Definitive Guide to Bond Index Investing.
Whether you are investing for the Short or Long Term, Bonds are a key component in a portfolio.
Today, we will spotlight the bond categories that we will explore in this guide. We will also go through bonds you may want to avoid, to accomplish your goals. Let’s dive in!
KEY TAKEAWAYS
- There are seven big categories of Bond funds that you may use for portfolio construction.
- For Long-term investors In the accumulation phase, High-Quality Government and Aggregate Bond ETFs are often preferred, as they reduce the risk in the portfolio and help with rebalancing. For such funds, most Investors tend to hedge currencies.
- Inflation Bond ETFs can provide further protection, but their long-duration can be problematic in certain European countries.
- For retired investors, Investment Grade Corporate Bond ETFs can help de-risk Equity portfolios while adding incremental yield.
- Short-Term Investors can choose Money Market Funds, or short duration Government or Investment Grade Corporate Bonds.
- More volatile bond segments include Emerging Markets or High-Yield Corporate Bonds. Both may exhibit a strong correlation with risk-on assets, such as Equities, limiting their utility in simple portfolios. NPL Funds are decorrelated, but rarely accessible.
Here is the full analysis
BOND ETFs: Asset Accumulators' SECRET WEAPON
1. Aggregate and Government Bond ETFs
You may be surprised to learn that Bond prices can be quite volatile. But that’s not necessarily a bad outcome for your portfolio. Consider the following examples:
- 12% Return in 2008 – In June 2007, the 10-Year US Treasury yield stood at 5%. Over the following 18 months, the S&P 500 lost almost 40%. Yet, US Bonds returned 12%.
- 34% Return between 2000 and 2003 – During the Dot Com crash, 10-Year Treasuries returned 34% over 3 years, while their starting yield was only 6.5%.
How was this possible? Wasn’t the yield on Bonds supposed to be Fixed? We will have a look at the mechanics in the next article, but what are the prerequisites to benefit from Bonds in stressful scenarios?
Market Mood Swings: Risk-On and Risk-Off
Here’s the deal. Apart from flat markets, there are two states of play in Financial Markets – risk-on and risk-off:
- In risk-on environments, investors flock to Equities, Emerging Market Bonds or Commodities, or countries exporting them.
- In risk-off environments, investors seek safe havens like US Treasuries, German Bunds, the US Dollar, Gold or the Swiss Frank.
To leverage the negative correlation with risk-on assets, you need bonds from the risk-off category.
We’ll dive into how to pick those Bonds in a detailed article soon. For the limitations of risk-on bonds, read on.
Risk On & Risk Off Asset Classes and Currencies
| MARKET ENVIRONMENT | ASSET CLASSES | CURRENCIES |
|---|---|---|
| Risk ON | Equities, Emerging Market Bonds, High-Yield Bonds, Commodities | EM Currencies, AUD, CAD, NZD, GBP |
| Risk OFF | US Treasuries, German Bunds, Gold | USD, JPY, CHF |
Should You Always Currency hedge?
For most investors, hedging Bond currency is preferable.
But there could be exceptions. Some advanced investors with a willingness to take additional risk may remain unhedged. Especially if they are based in countries that are in the ‘risk-on’ category. We will explain why in a dedicated article.
What about the Euro? It’s a tricky one as it funds carry trades, but at the same time is vulnerable to scenarios like 2011/2012. This has an impact on hedging strategy.
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- Licence to Yield – Which Bond ETFs for your goals? How do price change? Should you hedge currencies?
- Don’t get fooled by Wall Street – ESG Ratings are not designed to protect the planet. Adjusted for risk, ESG ETFs will also inevitably underperform. So how can you invest Sustainably?
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- Licence to Yield – Which Bond ETFs for your goals? How do prices change? Should you hedge currencies?
- Don’t get fooled by Wall Street – ESG Ratings are not designed to protect the planet. Adjusted for risk, ESG ETFs will also inevitably underperform. So how can you invest Sustainably?
Inflation-Linked Protection: No silver bullet
2. Inflation-Linked Bond ETFs
Inflation Can Eat Into Your Bond Returns
Nominal Bonds can sometimes let you down when inflation rears its head. That’s where Inflation-Linked Bonds step in – their coupons and principal are tied to inflation, serving as a potential counterbalance.
Watch Out For Pitfalls
However, Inflation-linked bond ETFs often have a higher duration, meaning they are more sensitive to changes in interest rates. If rates rise, the price of these ETFs can fall, potentially leading to losses for investors. This is particularly relevant for European and UK investors.
These Bonds also won’t help when Inflation is already priced-in. There is also a more personal issue. Inflation-Linked Bonds protect against officially reported inflation, but if an investor believes this does not accurately reflect their personal cost of living increases, these instruments may not provide full protection.
Are Inflation-Linked Bond ETFs right for you? We’ll tackle that question in another article.
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Most coaching participants come from the EU or the UK.
But we have consistent demand from all around the world. We provided coaching sessions to individual investors stretching from Argentina to New Zealand, or Guatemala to Japan.
A significant part of our clients are professionals in the Tech sector, Lawyers or Doctors that want to avoid costly mistakes when investing.
We also coach 25-30 year old young professionals that want to maximise assets for early retirement. We also have a large group of entrepreneurs that e.g. receive large lump sums after selling their company and want to invest it in financial markets. We speak to Crypto millionaires that want to reduce their risks.
Finally, some of our coaching clients are in their 40s or 50s and want to set up customised, income-producing portfolios or create Bond ladders for their retirement.
Most of the coached investors are in the 25–60 year old range.
Yes, some of our coaching clients have shared reviews on Google.
Some considerations are included below. For more details, consult your regulator’s website.
A financial coach is:
- Trained but not regulated
- Skilled at reviewing your overall financial situation and goals
- Able to help you develop a financial plan to achieve those goals
- Happy to discuss the pros and cons of various financial products but can’t recommend a specific one for you
- Comfortable working with anyone, whatever their situation
- Going to charge for their time
A financial adviser is:
- Regulated and authorised by the regulator to recommend specific products to clients or is independent and able to offer ‘whole of market’ solutions
- Often, going to charge an annual management fee, typically 1-2% of their client’s assets with initial fees on top.
We are proud to say that our coaching service has empowered a number of clients to reconsider their financial advisers’ offerings. From our clients’ feedback, in a number of cases, clients were overcharged, and offered unsuitable products, often due to conflicts of interest. However, this is not a rule. The best choice between a financial coach and adviser depends on an individual’s unique circumstances, including their financial literacy, time availability, comfort with managing their finances, and complexity of their financial situation.
Beginners often ask us:
- How do I reach my goals – What investments do I need to take into consideration for e.g. Taking a Sabbatical, buying a House or saving for Early Retirement?
- When should I invest – I fear that investing a lump sum in this market may have a negative impact on my returns. How can timing of buying ETFs affect my performance?
- How do I Invest – What are the pro and cons of investing with a Bank? Why should I diversify brokers?
- What should I consider investing in – What are some risks of portfolio diversifiers like Gold or Crypto?
- Avoiding Extra Costs – I have shortlisted a few ETFs, can you help me to compare them before I decide which one to buy?
- Benchmarking – What are educated investors doing in a similar situation to mine?
We are flexible. For example, answering some of these questions could help you avoid very costly mistakes:
- Challenging My Portfolio – Here is my portfolio – what am I missing? What could derail my strategy?
- Accelerating My Understanding – What are inflation linked Bonds? How are they different to Nominal Bond ETFs? What makes them outperform? Why do some investors add small cap value stocks to their portfolios? I want to exclude Tobacco companies from my portfolio – what are my options? What is Factor Investing?
- Simplifying Portfolio Maintenance – How can I diversify my investments? What is historically highly correlated so that I can consider removing it to keep my portfolio simple? How do I perform rebalancing? Does frequency matter?
- Reducing Risks – I want to understand the risks of investments – what are the different measures and how does it impact me? What are the risks of different types of brokerage accounts?
- Understanding the Impact of Recent Events – How do recent events impact my portfolio? What can I do to protect my savings from shocks?
- Investing Goals – I am investing for a specific goal e.g. Early Retirement, what is the research saying about e.g. the amount I need to have accumulated, how much can I withdraw annually? What are some calculators available and how to run them? What are the assumptions/shortcomings of these models?
- Comparing Equivalent ETFs – I have certain constraints in my tax-wrapper and can only select certain funds (e.g. I live in France and limited to specific synthetic ETFs). Which ETF characteristics should I pay attention to?
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Sometimes individual sessions are very helpful to get past your investing concerns. Our readers asked us to create coaching sessions. And we’re proud to say, that some of them even ditched their Financial Advisors, after experiencing the value we provide.
Most coaching participants come from the EU or the UK.
But we have consistent demand from all around the world. We provided coaching sessions to individual investors stretching from Argentina to New Zealand, or Guatemala to Japan.
A significant part of our clients are professionals in the Tech sector, Lawyers or Doctors that want to avoid costly mistakes when investing.
We also coach 25-30 year old young professionals that want to maximise assets for early retirement. We also have a large group of entrepreneurs that e.g. receive large lump sums after selling their company and want to invest it in financial markets. We speak to Crypto millionaires that want to reduce their risks.
Finally, some of our coaching clients are in their 40s or 50s and want to set up customised, income-producing portfolios or create Bond ladders for their retirement.
Most of the coached investors are in the 25–60 year old range.
Yes, some of our coaching clients have shared reviews on Google.
Some considerations are included below. For more details, consult your regulator’s website.
A financial coach is:
- Trained but not regulated
- Skilled at reviewing your overall financial situation and goals
- Able to help you develop a financial plan to achieve those goals
- Happy to discuss the pros and cons of various financial products but can’t recommend a specific one for you
- Comfortable working with anyone, whatever their situation
- Going to charge for their time
A financial adviser is:
- Regulated and authorised by the regulator to recommend specific products to clients or is independent and able to offer ‘whole of market’ solutions
- Often, going to charge an annual management fee, typically 1-2% of their client’s assets with initial fees on top.
We are proud to say that our coaching service has empowered a number of clients to reconsider their financial advisers’ offerings. From our clients’ feedback, in a number of cases, clients were overcharged, and offered unsuitable products, often due to conflicts of interest. However, this is not a rule. The best choice between a financial coach and adviser depends on an individual’s unique circumstances, including their financial literacy, time availability, comfort with managing their finances, and complexity of their financial situation.
Beginners often ask us:
- How do I reach my goals – What investments do I need to take into consideration for e.g. Taking a Sabbatical, buying a House or saving for Early Retirement?
- When should I invest – I fear that investing a lump sum in this market may have a negative impact on my returns. How can timing of buying ETFs affect my performance?
- How do I Invest – What are the pro and cons of investing with a Bank? Why should I diversify brokers?
- What should I consider investing in – What are some risks of portfolio diversifiers like Gold or Crypto?
- Avoiding Extra Costs – I have shortlisted a few ETFs, can you help me to compare them before I decide which one to buy?
- Benchmarking – What are educated investors doing in a similar situation to mine?
We are flexible. For example, answering some of these questions could help you avoid very costly mistakes:
- Challenging My Portfolio – Here is my portfolio – what am I missing? What could derail my strategy?
- Accelerating My Understanding – What are inflation linked Bonds? How are they different to Nominal Bond ETFs? What makes them outperform? Why do some investors add small cap value stocks to their portfolios? I want to exclude Tobacco companies from my portfolio – what are my options? What is Factor Investing?
- Simplifying Portfolio Maintenance – How can I diversify my investments? What is historically highly correlated so that I can consider removing it to keep my portfolio simple? How do I perform rebalancing? Does frequency matter?
- Reducing Risks – I want to understand the risks of investments – what are the different measures and how does it impact me? What are the risks of different types of brokerage accounts?
- Understanding the Impact of Recent Events – How do recent events impact my portfolio? What can I do to protect my savings from shocks?
- Investing Goals – I am investing for a specific goal e.g. Early Retirement, what is the research saying about e.g. the amount I need to have accumulated, how much can I withdraw annually? What are some calculators available and how to run them? What are the assumptions/shortcomings of these models?
- Comparing Equivalent ETFs – I have certain constraints in my tax-wrapper and can only select certain funds (e.g. I live in France and limited to specific synthetic ETFs). Which ETF characteristics should I pay attention to?
Bonds in Retirement: Higher Yield, tight Sleep
3. Corporate Bond ETFs
Corporate Bonds - A sweet deal?
Corporate bonds usually offer a higher yield than government bonds.
This can provide a retiree with a larger stream of income to support tax-efficient spending. The performance of corporate bonds is tied to both general economic conditions and the health of individual corporations, which can be somewhat different from the factors that influence government bond prices.
We will learn how to triage between good and bad bond quality.
Bonds For Near-Term Goals
4. Short-Term Bond ETFs
Why do Investors Like Short-Term Bonds?
Short-term Bond ETFs are not only a great way to park your cash if you save for a house deposit, a wedding or any other short-term goal, but they also are one of the best ways to hedge against inflation.
We will cover risk/return trade-offs with Short-term Bond ETFs.
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Bond Categories to Handle with Care
Why do Bond Investors Shy Away from The Highest Returns?
High Yield (HY) and Emerging Market (EM) Bond ETFs, while in theory promising higher returns, have two major flaws:
- Correlation – As Risk-On assets, they are highly correlated with Equities
- ‘Diluted’ Yield – At times, they suffer substantial losses. The actual yield is not as good as it may look.
5. High-Yield Bond ETFs
Almost as risky as Equities
- Spreads before January 2020 – before the full impact of the pandemic, the ICE BofA US High Yield OAS stood at around 3.5%.
- Spreads in March 2020 – As the pandemic intensified and equity markets declined, the high-yield bond spread surged to 11.5%.
That translated into a price drop of over 20% for HY ETFs, before the FED stepped in. From January to March 2020, the S&P 500 plummeted by around 25%.
- Spreads in May 2007 – prior to the full impact of the crisis, the high yield bond spread stood at approximately 2.7%.
- Spreads in December 2008 – As the crisis unfolded, the OAS surged. By December 2008, it had reached a peak of around 21%.
That translated into 45%+ price declines. The S&P 500 index experienced a sharp 40% decline during this period.
Don't Be Fooled by Yields
Typically, Yields are a good proxy for Bonds’ Expected Total Return, as we explain in the next article. However, this is not the case for HY Bonds.
- Bankruptcies – The long-term average HY default rate based on data from 1987 as collected by S&P is around 3.5%.
- Losses – It’s not unreasonable to assume 40-70% LGDs, as these Bonds rank junior to IG Bonds.
This means that between 1.4% and 2.5% of the yield may not be recovered, depending on where we are in the economic cycle.
Whether you are adequately compensated is another story and depends on the pricing and realised defaults.
Default Rates Based On Credit Rating
6. Emerging Market Bond ETFs
How Hedge Funds Go After Sovereign States
Now that you are familiar with the dynamic of HY Bonds, Emerging Markets (EM) Debt behaves similarly with respects to correlation and bankruptcies.
You may not like the stats of some defaults, unless you invest in a Vulture Fund, from the likes of Elliott Management. The fund bought discounted Argentine debt following the country’s 2001 default and then engaged in a long legal battle to be repaid in full.
This included an audacious move to have an Argentine naval vessel impounded in Ghana as collateral.
A couple of countries improved their Credit Ratings over time, but most debt remains speculative and has been for long periods in a state of default or restructuring over the past century.
External Debt Defaults and Country Risk: 1824-2001
| Country | Current S&P Credit Rating | Defaults | Percent of years in a state of default or restructuring | 12-month periods with inflation above 40% |
|---|---|---|---|---|
| Argentina | CCC- | 4 | 26.1% | 47% |
| Brazil | BB- | 7 | 25.6% | 59% |
| Chile | AA- | 3 | 23.3% | 19% |
| Columbia | BB+ | 7 | 38.6% | 1% |
| Egypt | B | 4 | 12.5% | 0% |
| Mexico | BBB | 8 | 46.9% | 17% |
| Philippines | BBB | 1 | 18.5% | 15% |
| Turkey | B | 6 | 16.5% | 58% |
| Venezuela | CCC+ | 9 | 38.6% | 12% |
| Group average | - | 5.2 | 27.4% | 25% |
Where Active Investing is King
7. NON-Performing Bond Funds
I have spent a few years managing some Non-Performing Loan Portfolios whether related to Corporates, Mortgages or other types of issuers. Some of the largest players in this field include Oaktree Capital or Apollo Asset Management.
It’s unlikely that have access to these funds, but in case you do, performance can be significant, and what’s best – negatively correlated to the Economic Cycle!
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Next Steps
Now that you have a grasp of what’s important and which Bonds you may use for your portfolio, let’s start with the most surprising property of Bonds – they are pretty volatile.
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