I have been seeing quite a few articles about the decline in bond prices and the bond bear market.
- Dreams of Big Bond Gains Backfire With $10 Billion ETF Loss
- U.S. Treasury bond rout deepens as popular fixed-income ETFs touch decade-plus lows
- Long Bonds’ Historic 46% Meltdown Rivals Burst of Dot-Com Bubble
- Retirements ruined after bond chaos hits pension savings
These are excellent headlines, but appear to be fighting the last battle.
Many investors appear to be evaluating fixed income investments without considering hold to maturity. Isn’t hold to maturity the primary way you should be evaluating fixed income?
You lend money to the borrower for a fixed amount of time, the borrower is contractually obligated to pay you a coupon, and at maturity give you your principal back. That is why they call it fixed income. The returns are not ambiguous. As a fixed income investor you care about yield, duration, and credit quality (i.e., getting your principal back).
Decades of declining interest rates appear to have made that framework fuzzy. With fixed income, declining yields lead to price increases. A long period of declining rates appear to have lulled fixed income investors to sleep a bit. Or distracted fixed income investors from the fundamentals.
However, if investors are focusing on the short-term price movements of fixed income investments, then they are trading, not investing. Price increases have historically not been what fixed income investors should be counting on. Again, fixed income investors should be focusing on yield, duration, and getting their principal back at the end of all that.
Expecting price increases in fixed income implies expecting lower rates in the future. Another dimension that investors need to realize is that the Fed does not control longer rates. The Fed sets short term rates. Longer rates are determined by many things including supply and demand and the inflation outlook. So the Fed could lower short rates, but that’s no guarantee that long rates follow suit. The yield curve is still inverted mind you.
This topic also ties into Howard Marks’ latest article where a main point was – if an investor could achieve their target returns with fixed income, why would they consider investing in equities. Marks is using the traditional framework for fixed income – hold to maturity. Short term price movements are not something to focus on.
ETFs could also be causing some issues here. ETFs tend to hold many issues, even if they are the same type, and therefore do not have a clear maturity date. For example, the iShares 7 – 10 Year Treasury Bond ETF (symbol: IEF) holds 13 issues with a 2.93% current yield, 4.69% 30 day SEC Yield, and weighted average duration of 8.37 years. So ETFs hold multiple issues, which are changing as the fund sells issues and purchases new ones. And, the yield is not fixed as is the case with a single issue. So, bond ETFs are sort of a composite issue, but not really, which also makes hold to maturity a bit fuzzy.
What is also interesting here is the difference between the current yield (last dividend annualized) and the 30 Day SEC yield, 2.93% and 4.69% in the case of IEF, respectively. The current yield is nowhere close to the yield on new 10 year treasuries, but this would be expected since older issues are yielding much lower rates. The fund cannot payout income it is not receiving.
The older issues would also have a current market price well below par. Those issues should theoretically increase in price as they get closer to maturity. Recall, bond investors will get their principal back at maturity unless the borrower defaults.
It is not entirely clear to me why the current yield and 30 day SEC yield differ so much, but presumably reflects the fact that some of the issues the fund holds are below par and would be expected to increase in price as they get closer to maturity. I am also unclear how price increases would eventually make their way into investors’ hands, since iit does not appear to be happening through the current dividend. It seems possible the funds are reflecting that “accrued interest” in the 30 day SEC yield.
All of that makes ETF bond funds a bit confusing and not exactly like an individual bond.
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