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May 15, 2015

The Elephant in The Room

What are you expecting from the bond portion of your portfolio over the next six years? 5%? 6%? 7%? These would all have been reasonable expectations in the past, but past is not prologue, especially when it comes to investing.
Whatever number you were thinking of, it is likely too high. Why?
  • The largest Bond ETF (BND) with over $27 billion in assets (Vanguard Total Bond Market ETF) has a yield of only 1.95%.
  • The second largest Bond ETF (AGG) with $24 billion in assets (iShares Core U.S. Aggregate Bond ETF) has a yield of only 1.85%.
  • The U.S. 10-year Treasury yield is currently 2.27%.
What does this have to with returns? As it turns out, everything.
In the bond market, the beginning yield has been the best predictor of forward returns bar none. The lower the starting yield, the lower the future return. The linear relationship is clear in observing the chart below.

As you can see, we are in uncharted territory today, off the graph in terms of an extremely low starting yield. There is not yet a six-year precedent for future returns starting from such a low yield. But unless the math on bonds has changed, we should be expecting among the lowest returns in history in the coming years.
There are only three sources of returns for a bond: (1) return of principal, (2) interest, and (3) reinvested interest from coupon payments. Before maturity, the value of bond will move higher and lower based on the direction of interest rates, but in the end your total return is likely to closely mirror the beginning the yield.
This is true for government bonds. For riskier issues like high yield bonds and leveraged loans, investors will also have to factor in default risk and a potential haircut to their return of principal.
For over 30 years, interest rates have been falling, a tailwind for both stock and bond investors.

But that prior tailwind comes with a price: lower future returns. Bonds have returned an average of 7.8% per year since 1976 (Barclays Aggregate Bond Index). If we’re being objective, they are unlikely to come anywhere near this return in the coming years.
We are already seeing the effect of low yields in looking at the largest bond ETF (BND) which has produced a total return of 6.17% over the past three years. That’s a 2.02% annualized return. During this period we saw bond prices fall as rates rose sharply in 2013 and bonds prices rally as rates fell sharply in 2014. In the end, though, the low starting yield was the overwhelming factor.

Elephant in the Room
As much as we would like to, we can’t change bond math. What we can do is start talking about this elephant in the room and what, if anything, to do about it. Low single-digit bond fund returns are not something most investors, both retail and professional, are preparing for.
But what can an investor do? Some options include:
(1) Saving more, spending less, retiring later.
(2) Taking more risk with an increased weighting to higher yielding bonds in the U.S. or emerging markets.
(3) Taking more risk with a higher weighting to equities.
The second and third options require changing ones risk tolerance which is neither easy nor advisable for most investors, particularly those nearing retirement. They also assume that returns will be sufficiently higher in those asset classes to compensate you for the additional risk, which may not be the case given the low yields in junk debt and high valuations in U.S. equities.
Which leaves us with the most unpalatable but also the most realistic option: expecting lower returns in the years to come and adjusting your lifestyle accordingly. Which is why it is the elephant in the room; who wants to talk about that?
Courtesy Charlie Bilello, CMT, Pension Partners
This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.  
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters. © EconMatters All Rights Reserved | Facebook | Twitter | Free Email | Kindle
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