Commentary by: Bilal Hasanjee, CFA®, MBA, MSc Finance | Senior Investment Strategist, Vanguard Investments Canada
Este artículo está disponible sólo en inglés.
Bond prices fluctuate but their total return is driven mainly by coupons and their reinvestment (or compounding effect), rather than the price alone.
High interest rates mean higher coupons or initial yields, and these factors matter more than the price. By staying invested in bonds, rather than cash, an investor can benefit from both higher yields and their compounding effect.
Rising rates have dramatically improved long-term median expected returns on bonds.
Traditionally, high-quality bonds have acted as a ballast in a multi-asset portfolio during major stock market drawdowns, such as the 2008 great financial crisis and, more recently, the Covid-19 related sell off in 2020.
Positive correlation between bonds and stocks does occur, but our research shows it is not long lasting.
Bond investors have experienced swift and deep losses in their portfolios over the course of the past year since the Bank of Canada, Federal Reserve and other major central banks started hiking interest rates in their fight against inflation. However, bond investors should remember the fundamental role of bonds in a multi-asset (including stocks and bonds) portfolio, to serve as a ballast against higher market volatility in stocks. That said, recent positive correlation observed between the two asset classes has perplexed investors about the utility of bonds in a portfolio. In this article we discuss two arguments: (1) Why rising interest rates will help drive higher returns for bond investors; and (2) Why we believe the positive correlation between stocks and bonds in 2022 is a unique one-off event and not indicative of a broader trend.
1. Coupons and their reinvestment are a major part of total bond returns – focus on income not just the price of a bond
Bonds are unique in that their returns consist of two parts: price return and coupons or income return. The income return comprises the compounded interest on bond coupon payments.
Long-term investors should consider the combination of these two components instead of solely concentrating on bond price returns. When interest rates fluctuate, the two components tend to move in opposite directions. Therefore, while higher rates may have a negative impact on bond prices in the short term, long-term investors will benefit by reinvesting and compounding at higher yields in the future. Figure 1 demonstrates that the income return, rather than the price return, has been the primary driver of bond investment performance over the long term when looking at Canadian, US and global aggregate bonds
Figure 1: Price and Total Returns for Canadian, US and Global Aggregate Bonds
Source: Bloomberg and Vanguard calculations
Equities and bond bear markets are different
As time goes on, the impact of the price return component on total return decreases for bond investors, while for stock investors, the price return component can be much more significant. This is exemplified in the "lost decade" between January 2000 and December 2009, during which negative price returns caused by bear markets had a significant effect on S&P 500 total returns, culminating to -0.9% annualized total return, including dividend reinvestment.
However, the bond bear market of the 1970s, although challenging due to rising inflation and nominal interest rates, provides a distinct perspective when considering the current investing climate. Investors who reinvested their income returns and exercised patience as compounding took effect, nearly doubled their capital in nominal terms from 1976 to 1983. Over the long term, bond total returns are primarily influenced by the reinvestment of interest income and compounding rather than price returns. Investors must look beyond the immediate losses reflected in their quarterly bond portfolio statements and focus on the potential long-term benefits of rising interest rates.
Figure 2: Coupons and compounding (reinvestment) constitute the largest part of total returns in bonds
Bond investing in the late 1970s and early 1980s
Bonds offer more advantages than cash in the current environment.
The power of compounding enhances during periods of high interest rates. By staying invested in bonds, investors benefit from both higher yields and their reinvestment or compounding effect. Many advisors have favored cash and cash equivalent bonds in recent years, fearing the potential impact of rising rates. The strategy has worked, briefly, as cash and very short-duration securities are much less sensitive to interest rate increases. But continuing to overweight cash may prove to be another example of how what worked in the past may not work so well again in the future. Consider the trade-offs of maximizing yield today by overweighting cash or very short-term bonds in the inverted yield curve environment compared with moving out the curve to take advantage of yields higher than they have been since the global financial crisis and better defend your portfolio from equity weakness.
2. Higher coupons mean lower duration or sensitivity to interest rates
When we look at the duration of a bond, we consider its price sensitivity to changes in interest rates. So, the lower the duration of a bond, the less sensitive its price is to movements in interest rates, and vice versa. Bonds with higher coupons have lower duration, compared to similar maturity lower coupon bonds, because they receive proportionately more coupon payments or cashflows until maturity. In other words, higher yields offer a greater cushion to absorb the shock of interest rate changes without leaving investors with large losses.
And therefore, initial or starting yields make a difference.
Initial yields make a difference
The initial or starting yield of a bond determines the performance of a bond investment. For example, short-term Treasuries are vulnerable to interest rate changes, and their total returns are most affected by changes in central bank policy. Due to adjustments in Federal Reserve policy, the interest rates on the short end of the Treasury yield curve have risen, causing an increase in the weighted average yield to maturity for funds that invest in these securities. This provides a more robust foundation to withstand any further rate shocks, as initial or starting yields are now much higher. Even if rates were to rise by an additional 200 basis points from the current level, investors would recoup any lost principal within a year and benefit from higher yields moving forward, ultimately increasing the long-term value of their bond portfolios as illustrated in Figure 3.
Therefore, we can conclude that the time it takes to recoup one's capital from an interest rate shock is determined by the initial yield. A 200 bp rate shock from a 75 bp initial yield will take longer to breakeven than a 200 bp rate shock from a 450 bp initial yield. Furthermore, if an investor's time horizon is longer than bonds portfolio duration, they should favor rate increases over rates remaining constant.
The bottom line is that as rates and yields move higher, bonds are more attractive, not less.
Figure 3: Rising rates help long-term bond investors
3. Bond yields have dramatically improved
Bond yields have improved drastically across Canada, US and global aggregate bonds over the past year and have reached levels not observed since 2007, as shown in figure 4. And rising yields have contributed to a marked improvement in bond return expectations over the past year.
Figure 4: Bond yields have significantly improved across the board
With rising nominal yield levels observed across developed markets because of higher inflation and higher interest rate expectations, we see a significant improvement in bond returns since the year-end, 2021, over the next 10 years, as described in Figure 5. At the end of December 2022, we anticipated that the median 10-year return for Canadian bonds will range from 3.4% to 4.4%, around a 2% p.a. increase from our forecast at year-end in 2021. Likewise, for global aggregate bonds (ex-Canada, hedged), we now anticipate median 10-year returns of 3.2% - 4.2%, over 2% p.a. improvement since the last year.
4. Bonds serve as a ballast in a multi-asset portfolio
Bonds usually act as a ballast in multi-asset portfolios by providing a hedge against market drawdowns.
The chart on the left in Figure 6 illustrates that even during the worst decile of U.S. equity returns, emerging-market equities (–8.7%) and global ex-U.S. equities (–7.8%) performed worse than their U.S. counterparts (–7.2%). This shows that globally diversifying an equity portfolio may not be enough to offer protection against U.S. equity underperformance because of the correlation across global equity markets. If an investor is seeking greater downside protection against U.S. equity market risk, then a well-diversified portfolio containing stocks and bonds seems to be the answer. In fact, during periods of equity market stress, high-quality fixed income acted as ballast, cushioning the losses in the equity portion of the portfolio. Moreover, the chart on the right shows that even during low yield environment, high quality bonds have offered more downside protection in a stock/bond multi-asset portfolio.
Figure 6: Bonds provide a ballast during equity drawdowns regardless of interest rate environment
Notes: Emerging-market equities are represented by the MSCI Emerging Markets Index; global ex-U.S. equities by the MSCI AC World ex-USA Index; U.S. equities by the Dow Jones U.S. Total Stock Market Index, U.S. REITs by the FTSE/NAREIT Real Estate Index U.S. high-yield bonds by the Bloomberg U.S. Corporate High Yield Bond Index; emerging-market bonds by the Bloomberg EM USD Sovereign Index; floating rate bonds by the Credit Suisse Leveraged Loan Index; U.S. cash by the U.S. Government 3-Month T-Bill Yield; U.S. corporate bonds by the Bloomberg U.S. Corporate Index; global ex-U.S. bonds by the Bloomberg Global Aggregate ex-USD Bond Index; U.S. bonds by the Bloomberg U.S. Aggregate Bond Index; U.S. municipal bonds by the Bloomberg Municipal Bond Index; and U.S. Treasury bonds by the Bloomberg U.S. Treasury Bond Index. The federal funds target rate is the upper boundary of the target range where applicable. All data begin in January 1988, other than the Dow Jones U.S. Select Dividend Index, which begins in January 1992; the Bloomberg Commodity Index, which begins in February 1991; the Bloomberg U.S. Corporate High Yield Bond Index, which begins in February 1988; the Credit Suisse Hedge Fund Index, which begins in January 1994; the Bloomberg EM USD Sovereign Index, which begins in January 1993; and the Bloomberg Global Aggregate ex-USD Bond Index, which begins in January 1990 (unhedged) and February 1990 (hedged).
Sources: Bloomberg and FactSet.
5. Stock-Bond positive correlation is not long lasting
Stock and bond returns have frequently moved in the same direction and have even been positively correlated at times. But as with any investment performance, looking solely at short periods will tell you only so much. As shown in figure 7, during much of the 1990s, stock-bond correlations were largely positive and have spiked into positive territory on numerous occasions since then. Correlations over the longer term, however, have remained negative since around the year 2000, and we expect this pattern to continue.
Figure 7: Stock-bond correlations tend to be negative over long term
Moreover, our research, based on data from 1976 to 2022, shows that the time periods when both stocks and bonds have experienced negative performance get shorter as the observation period extends. Figure 7 shows stocks and bonds have both experienced negative performance in the same month 15.3% of the time, over the same three-month period, 9.3% of the time, and over the same six-month period, 4.8% of the time. But these two asset classes have both experienced negative total returns over one-year periods only 1.8% of the time. And since 1976, investors have never experienced a three- or five-year period during which both stocks and bonds sustained losses.
While the current investing environment is challenging for investors, Vanguard’s long-term outlook on bonds is positive. We believe that investors should focus on long-term total returns on bonds rather than the prices and let higher interest rates work in their favor by allowing the compounding to take effect. Given the historically high yields, cash is no longer a good strategy because investors will lose the opportunity to compound at high rates. Lastly, bonds’ role as a ballast is proven and given current market volatility, uncertainty on monetary policy, an inverted yield curve predicting an impending recession and thus future lower interest rates, having a sizable allocation to bonds based on your risk-return profile, can serve as a good strategy for discerning investors.
Publication date: March 2023
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