Investing Basics: Confused by Bond ETFs?
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 even by pros Bond markets are widely misunderstood; by retail Investors, they are often just dismissed as ‘uninteresting’.
Yet Bond ETFs can lose 10% or 20%+ in a short timeframe; they can also ‘pop’ during a crisis delivering unexpected returns. Is keeping cash preferable in the current environment? Here are some answers.
Bonds are glamour
Some Bond ETFs are as volatile as stocks and since the 1980s trading Bonds became sexier than trading equities.
In his book, Liar’s Poker, Michael Lewis describes Salomon Brothers’ training program for new hires back then: ‘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, trading equities in Dallas, its smallest satellite office, which became training program shorthand for ‘Just bury that lowest form of human scum where it will never be seen again’
Why Bonds matter
Bond rates drive all markets, even equities, which is 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 in answering key questions:
- How much can I gain/lose by holding Bonds ETFs vs. Cash?
- Are Bond ETF losses temporary? If so, when will coupons offset any price losses for my Bond ETF?
- Is there any other upside of holding Bond ETFs vs. Cash?
Bond analysts usually sound smarter than equity analysts, because bond language is geeky; Bonds are complex, but that’s what drove their success.
Because 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 vanilla Government Bonds (Gilts) which you may buy for your long term 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; because you look at historical Equity ETF and Stock prices you also check them for Bond ETFs.
Equity prices indicate how bumpy the road ahead may be, and what returns you may expect. For Bonds, historical prices do not matter; apart from showing you that yields have gone down for decades, which you already knew, charts of Bond prices are quite useless.
A Bloomberg Terminal has a YAS Screen (Yield and Spread Analysis) allowing traders to calculate yields; Bond pros do not quote a $ price – they quote a yield.
Predicting the future gets even more interesting; while for Equities the future is largely unknown, for Bonds future returns are known – hence ‘fixed income’.
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 – held to maturity, with coupons reinvested at prevailing rates.
Short term Bond returns can diverge drastically from expected yield to maturity; for investment banks trading Bonds is a lucrative business.
For a long term Bond investor, regardless of fluctuations, holding to maturity locks-in the initial Yield; however how high rates rise, the Bond price is ‘pulled’ to par (initial or close to initial price) as maturity gets closer.
A quirk is that Bond ETFs have no fixed maturity date; Bonds are rolled so that the maturity range remains fairly constant.
What returns (Yield) can you expect on Bond ETFs, then?
The risk you take (DURATION)
Now you know Bond prices do not matter; what if I told you that you can also ignore coupon types, coupon rates or even Bond maturity dates?
In fact all those metrics can be aggregated to compare different Bonds (and Bond ETFs); the essence of Bond risk is then captured in one metric – Duration.
Yield to maturity is a good metric for what is earned over the life of a bond; duration is how long you need to hold the Bond ETF to earn that yield.
Short term pain….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 to endure. To illustrate, most Government or Aggregate Bond ETFs have a duration of 6 to 9 years, but some are longer.
Remember, cash by definition has a duration (and yield) of 0.
…. Long Term gain: Is there any possible (unexpected) upside opportunity of Bond ETFs?
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 ETFs.
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.
This happens 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 they increase in value.
This ‘price- pop‘ is directly related to the ETF duration – the higher the duration, the better the protection.
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).
Enough said now play with the calculator >
The calculator has two inputs – the Yield and Duration (the rest is optional); see some examples of the simulator in action
Is there anything else I need to know?
Rising rates are most often driven by higher inflation.
The returns you earn, and invested amount, are nominal; inflation reduces real purchasing power for Bond ETFs as it does cash.
This 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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