Cash Is Not Enough: Why To Hold Bond ETFs Despite Price Rollercoasters.

The Definitive Guide to Bond Index Investing - PART 3

Welcome to Part 3 of our Definitive Guide to Bond Index Investing.

Everyone has an idea about how the Stock market works. Yet, Bond markets are widely misunderstood. By Retail Investors, they are quite often labelled as ‘uninteresting’, to put it mildly. But Bonds play an important role in the overall success of your investment strategy.

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%. During the Dot Com crash, US Bonds returned 34% over 3 years, with a starting yield of only 6.5%. How was this possible?

Today, let’s play with a simplified Bond ETF calculator to get an intuitive sense of what is the upside and downside of Bond ETFs. And why keeping cash may not always be preferable.

KEY TAKEAWAYS

  • By knowing just 20% of Bond concepts, you can understand 80% of what matters in Government Bond ETFs. Yield-to-Maturity is a proxy of Expected Total Return. Duration is a proxy for the Risk you’re taking. 
  • But, in the Short to Medium-term, Bond Returns can differ widely from the initial Yield-To-Maturity. Prices will rally when interest rates drop and drop when interest rates increase. 
  • The higher the duration, the more ETF prices may move. Short-Term Bond ETFs and Money Market Funds have a very low duration. Low risk, means lower volatility. Cash has a duration of zero.
  • As a Long-Term Investor, rebalancing allows you to take advantage of drop in interest rates by buying cheaper Equities. The more duration risk you take, the more benefit you may reap. 
  • In most scenarios, in a rising yield environment, you are protected if you hold a Bond ETF for up to 2x duration. That’s why it is reasonable to choose a duration that is between half and your investment horizon.
Here is the full analysis

TWO THINGS TO WATCH OUT FOR WHEN SELECTING A BOND ETF

Why You need to understand Bond ETFs

For long-term investors, understanding the way Bond ETFs work, in a rising interest rate environment, can help, at the very least, answering some key questions:

But, I Will make it easy for you

There are also fundamental reasons why Bond analysts usually sound smarter than Equity analysts. One of them being, Bond language is geeky. But I think the Pareto Principle, aka the 80/20 rule also holds for Bond ETFs.

Grasping just two concepts, Yield and Duration, will help you understand 80% of what matters in selecting the right Government Bond ETFs. 

I let the 20% including all the jargon, with lower impact, aside. Ignoring it and setting some simplified assumptions can you help explain Bond ETFs to a Golden Retriever. In summary, when choosing a Government Bond ETF, consider its Risk and its Return:

  • The Yield-to-Maturity (YTM) is the Return you can expect.
  • The Duration is the Risk you take.

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What Return Can I expect from Bond ETFs?

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

You see, this is the main one misconception. Because you are used to looking at historical Equity ETF and Stock prices, you also check them for Bond ETFs. Yes, for Equity, historical 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 financial media show many charts of Bond prices? Frankly, apart from showing you that yields were going down over the past few decades, but you already knew that, they are quite useless. On a Bloomberg Terminal there is a YAS Screen, or short for Yield and Spread Analysis, which serves as base for traders to calculate yields.

Professional investors almost never quote a dollar price when they trade bonds. They quote a yield. 

The only time when traders quote a price on a bond is when a company or country is in potential trouble. But that’s for another article – here I assume you are buying high quality Government Bonds.

Yes, You can predict 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 largely 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.

That’s because, in the short term, Bond prices can move drastically. For Investment Banks, trading Bonds, in the short term, can be a lucrative business.

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

The most coveted desk was mortgage bonds. The least desirable, Equities

You may not know that since the 1980s, trading Bonds on Wall Street 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”. Issuing and trading nongovernment bonds (e.g. Mortgage Bonds) was the most lucrative part of all of them. But again, exciting as this may be, this merits a separate article.

You can play by different rules than Wall Street

While Investment Banks think short term when trading bonds, for a long-term investor, regardless of the fluctuation, holding them 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, so to speak, ‘pulled to par’. This pull means it will end up being the initial or close to the initial price as the time to maturity gets closer.

Is there a holding period that locks-in the yield?

There is a quirk, though. Bond ETFs usually don’t have a maturity date. Or rather, Bonds are rolled so that the ETF’s maturity range remains fairly constant. So, how long do we need to hold the ETF to lock in the yield, no matter how interest rates fluctuate?

Note: Look at Yield-to-Maturity when choosing a Bond ETF. Do not look at any of the following: 30-day SEC yield, 12-month trailing Yield or Dividend yield – these form part of Pareto’s 20% – the fairly irrelevant chunk.

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What are the Temporary Risks?

Painful DURATION

Now you know that Bond prices almost never matter. What if I told you that you can also ignore looking at coupon types, coupon rates or even Bond maturity dates? 

In fact, all those metrics can be aggregated up in order to compare the risk for different 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.

Upsides and Downsides of holding Bond ETFs

bond-yield-vs-price
Bond prices fall when interest rates rise. This is because the opportunity cost of holding a legacy bond that has a lower coupon than a newly issued bond rises

How Long Before You Recover Losses?

Duration is the risk of holding Bonds in a rising yield environment.

If your ETF holds longer bonds, with a fixed coupon, they rapidly become less attractive if new, higher-yielding Bonds, are issued. The price of the ETF needs to adjust to reflect that so that investors earn the same YTM.

So, if rates rise by 1%, your 8-year duration Bond ETF will drop by 8%. How long before you recover those temporary losses?  For Bond ETFs you sometimes need to be patient.

In a rising yield environment, you are protected if you hold the Bond ETF for a period up to 2x duration, in years.

Note: This period is fairly conservative and should provide protection in the vast majority of scenarios. The calculator illustrates the 2x duration year rule using simplified assumptions as described in the calculator’s notes. This approach has two purposes (i) it emphasises portfolio simplicity over complexity and (ii) it is designed for its objective, i.e. in an accumulation phase Investors rely mainly on Equities while bonds’ role is to provide stability and diversification. Decumulation phase investing, where liability matching is more important, will be discussed in future posts. During this phase, we can, similar to pension funds or insurance companies, use Fixed Income and Alternative Asset Classes for Asset/Liability matching. It does involve at least a couple of Bond ETFs, constant monitoring and rebalancing between them and average shorter duration given that investors are already in the retirement period.

Can it recover faster?

This time can be shorter. It does matter when rates stop rising. That’s why we created the Bond ETF calculator.

In a pessimistic scenario, over a 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. This is because you are taking more risk and earning potentially more return.

What is The duration of most Bond ETFs?

There are a number of Bond ETFs categories:

  • Money Market Funds are the shortest, below 1 year.
  • Short-term Bond ETFs are usually defined as below 5 years.
  • Currently, most Government or Aggregate Bond ETFs have a duration of 6 to 9 years.
  • But some, like US iShares TLT are longer, at about 18 years.

Physical Cash, by definition, has a duration and yield of 0. No risk, no return.

What are the Upsides?

Earning More Than Initial Yield

Now, here is the interesting part for Equity investors.

Is there any possible, unexpected, upside opportunity of Bond ETFs? Yes, it’s the other side of the coin. Since bonds decrease temporarily in price, they can also go up.

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. That’s because investors rush into in-demand safe-haven assets during a crisis.

And you benefit from this opportunity. This usually happens at the exact same time as Equity prices in your portfolio fall.

Bond ETFs will become a too large part of your portfolio, and you are likely to sell them, exactly at a time when they 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.

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.

Note: There could be even additional increases in price due to Convexity, in addition to Duration. For most Government and Aggregate ETFs – this forms part of the 20%, for more details read the calculator notes.

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Test YOur Understanding with the BOND ETF CALCULATOR

DO YOUR OWN SIMULATION

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.

The 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) – this scenario of interest rates increasing without break 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 real purchasing power.

However, the calculator allows you to compare the overall gain/loss in holding Bond ETFs relative to cash.

Check the simulated price vs. 100 (cash doesn’t change in price). Note that both Cash and simulated price will be equally affected by Inflation. In the short term, bonds will be more penalised because rates usually increase following inflation, which you can see with the duration concept.

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

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Next Steps

Now that you have a grasp of the duration aspect, let’s have a look at other characteristics of Bond ETFs, that are important for a Long Term Investor

Thank you for reading.
Good Luck and Keep’em* Rolling!

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