How tough is it to be a bond investor today?
There are many ways to measure the yield of a bond. The method most commonly used by money managers is Yield To Worst (YTW). YTW is the lowest possible yield that one can receive on a bond that could be retired early (or “called”) by the issuer. By taking account of the possibility of the bond being called, YTW is a more conservative measure of yield.
Then there is duration, another common metric in bond investing. It’s a measure of the sensitivity of the price of a bond to a change in interest rates. The higher the bond’s duration, the greater the change in the price of the bond for a given change in interest rates. This works in both directions: if interest rates go down, the price of a bond with high duration goes up a lot. But if interest rates go up, the price of a bond with high duration goes down a lot. Bonds with longer maturity usually have higher duration, though not always.
We can put these two concepts (YTW and duration) together to form a picture of how well we are being compensated for the bond price risk (or duration risk) we accept. For example, if my bond has YTW of 5% and a duration of 5, my YTW/duration ratio is 1.
In the decade leading up the financial crisis in 2008, U.S. bonds (as measured by the Bloomberg U.S. Aggregate Bond Index) routinely showed YTW/duration ratios > 1. But today that figure is about 0.2. Why? Mostly because interest rates have declined dramatically, as we all know.
What does a YTW/duration ratio of 0.2 mean? It means interest rates only have to increase about 20 basis points over a 12-month period before the decline in the price of the bond exceeds the yield received, resulting in a negative total return.
Today, U.S. high grade bonds are doubly unattractive: not only are yields extremely low; there’s also little protection if interest rates go up.
Tom Atteberry of First Pacific Advisors (FPA), who has managed fixed income portfolios since the mid-1980s, was recently asked if this is the worst opportunity set for bonds he’s seen in his career. Here’s his reply:
“If we think back at previous market selloffs in fixed income in the near late Eighties, early Nineties periods or the early 2000s, 2002, and then the Great Financial Crisis of 2007 and ‘08, as credit and other forms sold off dramatically because of economic problems or financial service problems, you were always able to sort of look to short Treasuries or other very high quality AAA investments and find yields that looked like inflation—might have been slightly higher than inflation—but where a reasonable return could be gotten and you could go high while the storm was upon you.
Today, the Fed seems to have taken out a massive quantitative easing hammer and taken that off the table. And for that reason, yes, this is the worst opportunity set because the ability to find things to go sort of high and ride out the storm are far fewer.”(1)
In other words, it is very tough to be a bond investor today. Great care is needed to manage both (i) short-term interest rate risk and (ii) long-term purchasing power risk.
And unfortunately financial repression isn’t going anywhere anytime soon.