Bond ETFs and rising rates finally explained – only 2 things matter (Bond ETFs vs. Cash)

Confused by Bond ETFs? 2 things that matter with rising rates (Bond ETFs vs. Cash)

confusing bond terms

Everyone has an idea about how the Stock market works.

Yet, Bond markets are widely misunderstood (even by some pros). By Retail Investors, they are quite often labeled as ‘uninteresting’, to put it mildly.

Most investors are still surprised to hear, that Bond ETFs can lose 10% or 20%+ in a short timeframe

They can also ‘pop’ during a crisis when you can get unexpected returns

You may wonder if keeping cash is preferable in current environment? Here are some answers.

Bonds are glamour

Some Bond ETFs are as volatile as Stocks. You may not know that since the 1980s trading Bonds became more sexy than trading Equities. 

In his book, Liar’s Poker, Michael Lewis describes Salomon Brothers’  training program for new hires back in those days.  

“After the end of the program, the new analysts are placed into various divisions of the firm with the most coveted desk being the mortgage bond desk and the least desirable one being Equities.”  

And particularly, equities in Dallas, one of the smallest satellite offices of the firm. 

Equities in Dallas became training program shorthand for 'Just bury that lowest form of human scum where it will never be seen again'

- Michael Lews, Liar's Poker

Why Bonds matter

Remember, rates drive all markets, even market dynamics within Equities. 

That’s why Wall Street tries to decipher every single nuance in Central Bankers’ speeches.

For long term investors, understanding the way they work, in a rising interest rate environment, can help (at the very least) answering key questions:

Can you please bring back the Golden Retriever?

geeky golden retriever
OK, but that's going to be a Geeky Golden Retriever

There are fundamental reasons why Bond analysts sound usually smarter than Equity analysts. One of them being – Bond language is geeky.

Bonds are complex. But that’s what drove some of their success starting from the 1980s.

But because I think the Pareto Principle (aka the 80% / 20% rule) holds for Bond ETFs as well, grasping just two concepts – Yield and Duration – will help you understand 80% of what matters in Bond ETFs

Especially for the more vanilla Bonds (Government), because that’s what you are likely to buy for your long term portfolio (Aggregate Bond ETFs hold a majority of Government Bonds, too)

I let the 20% including all the jargon, with low(er) impact, aside. Ignoring it can you help explaining Bond ETFs to the Golden Retriever. After all, it’s one of the building blocks of the Golden Retriever Portfolio.

Here is an attempt to demystify Bond ETFs  including a Bond ETF Calculator that only takes these two inputs (!) to get intuitive sense of what is the upside/downside of Bond ETFs vs. Cash

The Return you get (Yield)

You don't need a price when you trade a Bond

You see, this is the main one.

Because you are used to looking at historical Equity ETF and Stock prices you also check them for Bond ETFs.

Yes, for Equity prices give you an indication of how bumpy the road ahead may be. And what returns you may expect in the long run.

But here is something that may sound unintuitive – for Bonds, historical prices do not matter. 

Why do we so many charts of Bond prices? Frankly, apart showing you that yields were going down for the past few decades (you already knew that), they are quite useless.

On a Bloomberg Terminal there is a YAS Screen (Yield and Spread Analysis) which serves as base for traders to calculate yields. 

Professional investors do not quote a dollar price when they trade bonds – they quote a yield.

Predicting the future

And it gets even more interesting.

While for Equities the future is largely unknown, for Bonds despite all their quirkiness the future returns are known (after all the products are called Fixed Income)

As Jack Bogle noted, Since 1926,  the initial yield on the 10-year Treasury explains 92% of the total return an investor would have earned over the subsequent decade.

But there is an important condition: you need to hold them to maturity and reinvest the coupon payments at prevailing rates.

In the short term Bond returns can diverge drastically from expected Yield to Maturity*. For Investment Banks trading Bonds can be a lucrative business. 

For a long term investor, regardless of the fluctuation, holding it to maturity locks-in the initial Yield

No matter how high rates rise between the time you invest and maturity, the Bond  price will be ‘pulled’ to par (initial or close to initial price) as the time to maturity gets closer. 

There is a quirk, though. For Bond ETFs there is no fixed maturity date… Or rather, Bonds are rolled so that the maturity range remains fairly constant. 

What returns (yield) can you expect on Bond ETFs, then?

(* do not look at 30-day SEC yield, 12-month trailing Yield or Dividend yield – these form part of the 20% – the fairly irrelevant chunk)

The Risk you take (Duration)

Now that you know that Bond prices do not matter…

What if I told you that you can also ignore coupon types, coupon rates or even Bond maturity dates? (to name a few)

In fact all those metrics can be aggregated up in order to compare different Bonds (and Bond ETFs).

The essence of Bond risk is then captured in one metric – Duration.

While yield to maturity is a good metric for what is earned over the life of a bond, duration is the basis for how long you need to hold the Bond ETF to earn that yield.

Short term pain ...

For Bond ETFs you sometimes need to be patient – in a rising yield environment you are fully protected if you hold the Bond ETF for a period of roughly 2x duration (in years)

This time can be shorter – it does matter when rates stop rising (hence my Bond ETF calculator)

But in the most pessimistic scenario, over 2x duration period the increased rates dragging the ETF price down will be fully offset by newly issued Bonds’ higher coupons.

In a nutshell, the longer the duration of the ETF, the more pain you have to endure. To illustrate, most Government or Aggregate Bond ETF have a duration of 6 to 9 years (but some like iShares TLT are longer, at about 18 years). 

As a reminder, Cash by definition has a duration (and yield) of 0 (or close to for Money Market Funds)

... Long Term gain?

Is there any possible (unexpected) upside opportunity of Bond ETFs?

Yes, while holding Bond ETFs during the investment horizon is the goal as part of your portfolio allocation, rebalancing is probably the only thing you need to do with your portfolio over that investing horizon.

The upside comes precisely from the fact that you won’t hold all of your Bond ETFs for the length of your investment horizon.

Selling during a crisis means that, you (may) end up earning more than Yield to maturity on some of your Bond ETFs.

Remember in certain recessionary scenarios, as yields fall, Bond ETF prices will rise. While the long term yield is known, short term returns can be higher than expected (because investors rush into in-demand safe-haven assets during a crisis). 

And you benefit from this opportunity.

This happens at a time when Equity prices in your portfolio may fall. Bond ETFs will become too large part of your portfolio and you are likely to sell them, exactly at a time when these increase in value.

This ‘price pop is directly related to the ETF duration – the higher the duration, the better the protection (and sometimes even more* – Read the calculator description)

You can use that increase in price to sell Bond ETFs and buy cheaper Equities during a market crash. It’s part of a proper preparation to benefiting from the next recession!

That’s why it’s key to compare yields for a certain duration (it’s the return you get for the risk you take).

(* There could be even a bonus called Convexity, in addition to Duration but for most Government and Aggregate ETFs – this bonus forms part of the 20%, for more details read the calculator notes)

BETTER THAN WORDS - SIMULATE YOURSELF with the calculator

Two inputs - the Yield and duration (the rest is optional)
On 19th September 2020, IEF Bond ETF quoted at 121.67 with a yield to maturity of 0.75%

Using the Bond ETF Calculator, let’s simulate the following scenario for iShares IEF Bond ETF:

  1. Starting yield to maturity of the ETF is 0.75% 
  2. Rates rise over 2 years at a rate of 2% per annum
  3. After 3 years a recession forces the Central Bank to lower rates to 1%
Rising Rates Scenario
You can click on the Market Yield legend label to select one curve

The first 6 months actually happened, so it can serve to back-test how the calculator simulates reality:

  • After 6 months, the ETF price dropped from 121.67 to 113.0. We also need to add the dividends that the ETF paid (since it’s a distributing ETF) of 0.39 giving a total return equivalent price of 113.4 (ignoring interest on interest for sake of simplicity, given it’s a short time horizon)
  • The calculator price after six month is 113.0 (the calculator takes a total return price approach)
  • The calculator captured approx. 90% of the actual price behavior despite its limitations and potential issues with exact market prices.
ETF Price 'pop' during a market crash

In my illustrative scenario, investors will have endure more losses – in fact the price will drop further and bottom out at 96.8.

Central Bank action provides a simplified ‘pop’ effect on the price that jumps to 126 after 3 years, with a 3-year annualized return of 1.2% – above the initial Yield to Maturity of 0.75%.

The positive shock is very significant since rates drop by 4% which would take some time in reality. It illustrates the concept, though. Also, Central Banks are becoming more aggressive in their stimulus with each crisis.

No 'pop' bonus
2 times duration rule - no market crash
Bond ETF Calculator settings: YTM 0.75%, Current price: 121.67, Duration: 8 years, Expected Rate Hike: 2%, Last Year of Hike: 2, Start of Next Recession: OFF

In my scenario, the investor ended up earning more than Yield to Maturity because of the recession.

If a recession didn’t materialize (same settings including Last Year of Rate hike = 2 but turn Start of Next Recession OFF) , the Yield to maturity would have been achieved after 9 years. And then would start moving  higher at each subsequent period.

2x Duration rule
2 times duration rule
Bond ETF Calculator settings: YTM 0.75%, Current price: 121.67, Duration: 8 years, Expected Rate Hike: 2%, Last Year of Hike: OFF, Start of Next Recession: OFF

But what is the absolute worst case (if we also turn off the Last Year of Rate hike)? The investor achieves a Yield to maturity after 16 years (2x duration rule) – this scenario seems rather absurd, but illustrates how the rule works. 

Hence, in practice the yield to maturity is achieved much earlier.

Is there anything else I need to know?

Yes, Inflation is the main one. Rising rates are most often driven by higher inflation. 

The returns you earn (and the invested amount) are nominal and you lose out real purchasing power. 

But this article brought some nuances of holding Bond ETFs vs. Cash. Both will be equally affected by Inflation. 


This, along with its implications merits a separate post.

Here is the (beta) version of the calculator – test it out for your preferred Bond ETF and let me know what you think.

 

Bond ETF Calculator – Run your scenario and test how rising rates may affect your Government Bond (and to a great extent Aggregate Bond) ETF

BOND ETF GUIDES (US and EUROPE)

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DISCLAIMER

All information found here, including any ideas, opinions, views, predictions, forecasts, commentaries or suggestions expressed or implied herein, are for informational, entertainment or educational purposes only. The information provided on Bankeronwheels.com is general in nature only and does not constitute personal financial advice

Before acting on any information contained on Bankeronwheels.com you should consider the appropriateness of the information having regard to your objectives, financial situation and needs, and seek professional advice where appropriate. Read the full disclaimer.


HAVE A QUESTION ABOUT INVESTING?

Drop it below or if you enjoyed my work and found it useful please do leave a comment or share it with someone that may benefit from it – I am grateful for your feedback

Note that this website is non-revenue generating. In addition to time I dedicate to this, I pay for hosting and software to provide you with the analysis

Good luck and keep’em* rolling!

(*Wheels & Dividends)

Raph

 

REACH FINANCIAL INDEPENDENCE SOONER

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Maciej
Maciej
1 month ago

Raph, I wanted to comment on convexity, inflation etc. but…this golden retriver photo is so cool:) Above post is so simple and in the same time so full of content. Really great reading. Thank you:) Just noted (on bogleheads forum) that in 2020 version of „Random walk…” Burton is recommending to replace Total Bond Market with Dividend Growth Stocks, EM Bonds and Corporate Bonds. Book is of course really good one but this particulary advice for me sounds quite odd as I do not see Equity & EM bonds as subsitutes for high quality bonds. Any thoughts on that? Maybe… Read more »

Last edited 1 month ago by Maciej
Maciej
Maciej
1 month ago

Read some stuff on retirement portfolio construction and self dividends aka consumption phase (e.g. on portfoliocharts.com and earlyretirementnow.com) and I have to admitt that building portfolio for withdrawals is more complex and interesting than for accumulation (sequence risk, home country inflation, SWR/PWR, tax consideration etc.).

However the bottom line was that dividend stocks are not an answer to address sequence risk so Burton advise sounds odd even from income generation but I’m from Main street;)

Anyhow, waiting for post on Cash vs. Bonds. For me cash has undeserved bad PR;)

Matteo
Matteo
1 month ago

Excellent contents as always, thank you Raph!

Simon
Simon
1 month ago

Thanks Raph, this is a great post and I enjoyed reading. It’s a question I have been asking myself a lot recently – why even both buying bond ETFs if rates are so low and have more space to move up than down. Last year I had come to the conclusion to hold mainly cash instead of bonds, but to keep a small bond allocation for learning/experience purposes. This article shows a much bigger picture and is making me re-think that assumption, especially giving insight that you can still grow longer term even if rates rise in short term. It… Read more »

Olek
Olek
1 month ago

I don’t hold any bond ETFs because I still don’t fully understand how they work. 100% stocks FTW 🙂

John
John
1 month ago

Raph –

I went through a number of blogs/websites to understand Bond ETFs but this really stands out by the simplicity of how you explain it.

Many thanks for all the efforts,
John

M MX
M MX
1 month ago

Thank you Raph. What about ETFs of Inflation-linked bonds? Can these be a good protection against inflation? For example IGIL – iShares Global Inflation Linked Govt Bond UCITS ETF USD 

M MX
M MX
1 month ago

Thanks, I’m already a subscriber for a while and learning a lot.

Bryan
Bryan
1 month ago

A thoughtful post and an interesting tool. It gives a stark demonstration of the potential gains that can be made from bonds in the event of interest rates suddenly falling. But it does take the self discipline to rebalance when the equity markets are at their scariest. I will look forward to a post on the role of bonds post retirement.

Dave
Dave
1 month ago

Hi Raph, Thanks for all your amazing work! What are your thoughts on Bonds vs a High Interest Savings Account (HISA). Here in Australia we can get 1.35% in a fully guaranteed HISA. Our Reserve Bank rate is 0.01% and likely to increase as we have very high housing growth. Thanks! Dave.

Last edited 1 month ago by Dave
MiCv
MiCv
29 days ago

Dear Ralph, Thank You for exceptional explanation. As bond ETF duration is so important, is there a place where we can compare them? I found duration info only in ETF fact sheet, I am surprised that sites as justetf.com do not provide duration data in their tables. Have a nice day!