This commentary is available as a PDF here.
- Popular bond ETFs have had spectacular year-to-date returns.
- Capital gains in bonds are not the same as capital gains in equities. Rather, current capital gains in bonds come at the cost of lower future returns.
- Any further bond rallies will imply falling rates. The danger is that at present levels, and without rates going negative, bonds may not have enough room to run to offset equity losses in the case of a crisis.
ETFs representing core bonds have had a strong year. AGG (Barclay’s US Aggregate ETF) is up 5.17%, IEF (7-10 year U.S. Treasuries) is up 6.93%, and TLT (20+ Year U.S. Treasuries) is up 16.13%.
It almost makes you wonder: why even bother buying stocks? After all, while the S&P 500 may have made all-time highs this week, it was only after hovering around the 2000 level for 18 months and suffering two 10%+ sell-offs along the way.
But gains in bond portfolios due to falling rates are nothing to be jealous of. If anything, they should give us pause for concern.
Sell or hold? It doesn’t matter.
Unlike stocks, bonds have a well-defined value. With contractually defined coupon payments and maturity date upon which the principal is repaid, a bond can be neatly priced as the net present value of its future cash flows.
Most investors understand that bonds change in value when interest rates change. As prevailing rates go down, the value of existing bonds go up. When prevailing rates go up, the value of bonds go down.
Note: To keep life simple, in the rest of this commentary we will assume there is a single interest rate that applies across all bond maturities. We’re also going to ignore the fact that investors can sell their bonds to buy other assets. While real life is more complicated than what we’re going to discuss, the overarching theme of this commentary is still practically relevant.
The argument why this happens is fairly trivial. Let’s assume that the prevailing interest rate is 5%. We buy, at par, a 10-year bond with $100 face value and $5 annual coupons.
Five years later, the prevailing interest rate has dropped to 2%. Our 10-year bond is now a 5-year bond, but it continues to pay $5 coupons. Newer 5-year bonds offered at par with $100 face are only offering annual $2 coupons.
Intuitively, the bond we’re holding must be worth more than $100. After all, it has all the same features as the current 5-year bonds, but the coupon payments are higher. If the current bond can be bought for $100, ours must be worth more.
The question is, how much more? The answer is resolved, again, in a fairly intuitive manner.
As the bond holder, we have two choices. First, we can hold the bond for the next five years and collect our coupons. Second, we sell the bond and invest the proceeds in the current 5-year bond.
Other investors also have two options. They can buy the current 5-year bond or they can try to buy our bond from us.
If an investor wanted to buy from us, what price would she offer? Remember that at maturity the bond is going to return the $100 principal. So any amount paid over $100 is effectively sacrificed, lowering the effective yield (called the yield-to-maturity) that the buyer actually realizes. Why would a buyer do this? Well she might be willing to pay more than $100 if the effective yield she earns is still higher than the 2% yield she can achieve buying the newly issued bonds.
Back to our perspective as sellers. With the current bond we hold, our effective yield is 5%. If we sell, we’re going to have to reinvest the proceeds at the much lower rate of 2%. Therefore, we’re going to demand a premium for our bond sufficient enough to offset the lower rates we’ll be reinvesting at to make sure we’re earning at least a 5% annual total return when all is said and done.
So can there be a happy middle ground where the buyer pays a low enough price that they earn an effective yield more than 2% but as sellers we receive high enough a price that our effective yield more than 5%?
Of course not! There is no financial alchemy here that can create extra returns for both buyer and seller.
Extra return generated for the buyer will be at the cost of the seller and vice versa. Assuming shrewd buyers and sellers, we’ll end up at a point of exact parity: the price offered for the bond will give the seller exactly a 5% effective yield and the buyer a 2% effective yield.
There is no free lunch here. In an efficient market, we’re indifferent between holding on to our existing bond until maturity and selling it to lock in our capital gains and re-investing the proceeds.
So while on paper our bond may appear to be worth considerable more than when we bought it, we can’t actually realize a higher return than the yield we locked in when we originally bought the bond.
Today’s gains are tomorrow’s returns
Investors accessing bonds through ETFs rarely end up holding the actual bonds to maturity. Instead, they often buy constant maturity portfolios. For example, a 10-year constant maturity bond portfolio will only hold 10-year bonds. As the bond ages, it is sold and the proceeds are used to buy a new 10-year bond.
At the beginning of the year, the 10-year U.S. Treasury (“UST”) rate was 2.27%. Today, it sits at 1.60%. As we demonstrated in the last section, this decrease in rate implies that the value of the bonds we bought at the beginning of the year are now worth more. IEF (7-10 year USTs), for example, is up 6.93%.
As we mentioned in the last section, however, as bond holders we should be indifferent between holding to maturity and selling. In our example, we held a 10-year bond for 5 years before we considered selling. In a purely hypothetical constant maturity index, we instantaneously roll our portfolio every moment of the day, always holding a portfolio exactly 10-years in maturity.
Again, there can be no magic return created here from the portfolio turnover. Any premium we earn in selling our bonds due to an instantaneous change in rates must imply that the yield we are going to earn re-investing in the next batch of 10-year bonds must be lower.
The lesson here is that today’s paper gains are just tomorrow’s yield returns realized early. IEF may be up 8.82% year-to-date, but the 10-year annualized expected return for 10-year USTs just fell by 67 basis points. That may not sound like much, but the total return difference between a 2.27% annualized return and a 1.60% annualized return over a 10-year period is 7.96%. The paper gains we have today are simply the yield returns we won’t be receiving in the future.
Note: In the real world, constant maturity indices often span a few years. For example, IEF holds U.S. Treasuries with 7-10 years of maturity, and generally there exists a term premium that can be earned in the roll from 10 years to 7 years in maturity as the yield curve is not flat. Nevertheless, the general premise holds: capital gains from changes in rates have very little impact on long-term returns of the portfolio.
The last 15%
The bigger problem here is that without 10-year rates retreating to higher levels (implying bond values fall), or without 10-year UST rates going negative, the most 10-year bonds can rally in value from this point is 15.3%.
That’s it. We’re at the last 15%. If prices rally that much, it means 10-year rates must be at 0%, at which point there is zero expected forward return.
This is a problem for two reasons. First, it highlights how little juice is left to squeeze in this bond rally. Holding 10-year USTs today almost guarantees a negative post-inflation return over the next decade.
Second, it calls into question the efficacy of currently using fixed income as a hedging instrument in a market crisis.
Consider that from peak-to-trough during the dot-com sell-off (March 10, 2000 to October 9, 2002), the 10-year U.S. Treasury rate fell from 6.39% to 3.61%, a 2.78 percentage point move. During the peak-to-trough sell-off of the Great Recession (October 9, 2007 to March 10, 2009), the 10-year U.S. Treasury rate fell from 4.67% to 2.89%, a 1.78 percentage point move. We know that capital gains in these positions were at the cost of future yield returns, but they helped significantly offset equity losses during the period.
Today, without rates going negative, the absolute maximum a 10-year UST could rally during a market crisis is 15%.
From October 9, 2007 to March 9, 2009 the SPDR S&P 500 ETF (SPY) returned -55.19%. The iShares 7-10 Year U.S. Treasury ETF (IEF) returned 20.15%. A traditional 60/40 portfolio would have returned -25.05%.
If a similar crisis were to occur today, 10-year rates would have to fall below 0% to offer similar protection.
So returns in bond portfolios this year due to falling rates are nothing to be jealous of. We should be worried: worried not only about the absolutely miserable return core fixed income is going to be able to provide over the next decade, but also worried about whether fixed income will be able to protect us in the case of a market crisis.
 Par is a term used to imply that the price paid is equal to the face value.