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The Single Best Predictor of Bond Returns

What are you expecting from the bond portion of your portfolio over the next five 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 (AGG), with over $41 billion in assets, has a current yield of 2.13%.
  • The second largest Bond ETF (BND), with over $31 billion in assets, has a current yield of 2.41%.

What does this have to do with returns? As it turns out: everything.

In the bond market, the beginning yield has been the single best predictor of forward bond returns. The lower the starting yield, the lower the future return. The higher the starting yield, the higher the future return. The linear relationship is clear.

bonds1

Five years ago, the yield on the Barclays Aggregate Bond Index was 2.24%. What have bonds done since? The two largest bond ETFs (BND and AGG) have returned 10.04% and 10.28% cumulatively, or 1.93% and 1.98% annualized. As predicted by their low beginning yields, these are among the lowest 5-year returns in history (annualized return for the Barclays Aggregate since 1976 is 7.5%).

bond-returns-12-20

The 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 institutional, are prepared for.

But what can an investor do? There are three main options:

(1) Take more risk with an increased weighting to higher yielding bonds in the U.S. or emerging markets.

(2) Take more risk with a higher weighting to equities.

(3) Save more, spend less, retire later.

The first and second 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 other asset classes to compensate you for the additional risk, which may not be the case given the lower yields in junk debt and higher 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. Save more, spend less, retire later (I know, who wants to hear that?).

And hope for higher interest rates as that will be the only long-term cure for low bond returns.

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Further Reading:

Bonds and Stocks: Potential Double Trouble (Barron’s)

The Only Cure For Low Bond Returns is Rising Rates

Bond Math and the Elephant in the Room

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.

CHARLIE BILELLO, CMT

Charlie-Bilello

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

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