Confused by Bond ETFs? 2 things that matter with rising rates (Bond ETFs vs. Cash)
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.
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?
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)
Using the Bond ETF Calculator, let’s simulate the following scenario for iShares IEF Bond ETF:
- Starting yield to maturity of the ETF is 0.75%
- Rates rise over 2 years at a rate of 2% per annum
- After 3 years a recession forces the Central Bank to lower rates to 1%
Rising Rates Scenario
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
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
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 GUIDES (US and EUROPE)
BEST BOND ETFs in 2021 for US Investors Current Annual Yields for Bond ETF Types January 2021 – Current Yield to Maturity for different Bond
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