After a decade of the Fed and other global central banks pushing interest rates down to historic lows and holding them there, the past three years have been a shock to bond investors. The 30-year Treasury bond yield bottomed at 0.99% in March 2020, but has soared to over 5.00% recently. Owners of long-term bond funds have seen cumulative losses approaching -50%, rivaling the worst stock market declines of recent decades.
Yet while the overall picture for bonds has been bleak, other bond investing approaches have held up considerably better. For example, SMI’s Bond Upgrading strategy is down only -5.3% since many rates bottomed in August 2020. That’s markedly better than the -16.8% loss of the Bloomberg U.S. Aggregate Bond Index over that time, and miles ahead of the -50% loss incurred by some popular bond ETFs.
What accounts for these dramatic differences in recent bond performance? Let’s dig in.
Bond Investing 101
At SMI, we try to teach what you need to know about investing without burdening you with all there is to know. That said, becoming a successful investor generally involves also becoming a more knowledgeable investor. This topic of bond risk is presented in that vein. It’s a little more challenging than some of our content. But before we’re through, we think you’ll see how it can help you be a more successful investor, especially if your asset allocation calls for a portion of your portfolio to be invested in bond funds.
Before we pull back the curtain on bond risk, let’s review a few bond basics. When you buy a bond (which is essentially a glorified IOU), you’re acting as a lender. You are lending your money at interest to a company, organization, or government. In contrast, when you buy a stock, you’re acting as an owner. You are buying a partial equity stake in a company.
There are two major risks when it comes to buying bonds. Credit risk speaks to the fact that you might not get all your money back. You’re counting on the borrower to be creditworthy — to keep making interest payments and pay off the bonds when they mature. The most common way to minimize credit risk is to diversify, spreading your holdings among different bond issues, which is exactly what bond funds do.
The second major risk for bondholders, and the one that often poses the bigger threat, is interest-rate risk. That speaks to the possibility that you could get locked into a below-market rate of return. It is the same risk you face when trying to decide how long to tie up your money in a bank CD, but it has even greater significance when investing in bonds. Suppose you invest in a one-year CD, but rates rise after six months. You’ll miss out on the higher returns for the final six months of your term. But with long-term bonds, it can mean enduring years of inferior performance. That’s why when interest rates go up, bond prices go down, and vice versa.
The longer you have to wait until a bond reaches maturity, the longer you’re vulnerable to interest-rate risk. To shorten the wait (and reduce the risk), investors can simply buy bonds that were issued many years ago and are now only a few years from their maturity. The shorter the maturity, the less volatile a bond’s price will be. Likewise, the shorter the average maturity of all the individual bonds held by a bond fund, the less volatile that fund’s price will be.
This explains why bond investors have commonly relied on a fund’s average weighted maturity when assessing risk. It provides some sense as to how long it will take for the collection of bonds in the fund to mature. The higher the number representing the average weighted maturity, the longer the term (and hence, the higher the risk) of the overall bond fund.
As helpful as the average weighted maturity is, it doesn’t tell the whole story of a bond fund’s risk. It looks only at the amount of time before the principal of the bonds is due to be repaid. But bondholders also receive regular interest payments over the remaining life of a bond. Let’s say you have a $10,000 bond with a 5% rate that’s due to be fully repaid in 20 years. Average weighted maturity takes the 20 years into account but ignores the $250 in interest received every six months.
So financial pros developed a better calculation for measuring bond risk. It goes by the name duration and is equal to the average weighted maturity of all the principal and interest payments due to flow into a bond portfolio.
Including the interest payments makes duration a much more precise way to predict bond-fund volatility. In fact, the duration of a bond fund can tell you roughly how much its value is likely to change in response to a change in interest rates. For every percentage point (1%) change in interest rates, the fund’s price will move in the opposite direction by a percentage roughly equal to the fund’s duration.
How duration predicts risk
Here’s how this information is helpful. Since 2015, SMI has recommended that Bond Upgraders split their bond portfolios into two pieces. One-half of the bond allocation is invested equally between two “permanent” Vanguard index-fund holdings. The other half of the bond allocation is invested in a rotating “Upgrading” fund that changes periodically (see Table 2 on this page).
The first of the two permanent bond holdings is the low-risk Vanguard Short-Term Bond Index, with an average duration of 2.6. This duration figure means that if interest rates were to rise one percent over the next year, the value of the bonds in this fund would fall approximately 2.6%. When that loss is subtracted from the fund’s current yield of 2.0%, the expected return for the year would be a loss of roughly -0.6%. This is why bond investors get nervous about interest rates rising!
Our other permanent bond-fund recommendation is the slightly higher-risk Intermediate-Term Bond Index, with an average duration of 6.3. Under the same interest rate scenario, we would subtract this fund’s expected loss of 6.3% from its current yield of 2.8%, leaving us with a total expected loss of -3.5% for the year.
A glance at the Long-Term Bond Index fund explains why we don’t have a permanent allocation to long-term bonds (although we can own them at times in the rotating “Upgrading” slot of the portfolio). Its duration of 14.1, coupled with a modest current yield of 4.1%, means that a one-percent rise in interest rates could leave this fund’s owners with losses of roughly -10.0%. Ouch!
Bond market sweet spot?
Historically, intermediate-term bonds have inhabited the “sweet spot” of the bond market, where the risks and returns are most optimal for investors. Moving from short-term bonds to intermediate-term currently carries with it an increase in risk (represented by duration) from 2.6 for short-term to 6.3 for intermediate-term. Our reward for this increased risk is a relatively modest boost in current yield from 2.0% to 2.8%.
If that seems like a bad trade-off, keep in mind that rates typically fall during recessions, which we think is still a reasonably likely outcome in the year ahead. So the real question is whether the reward of continuing to own some intermediate-term bonds — which would benefit from falling rates during a recession — is worth the downside risk should rates continue to increase. For this portion of our Bond Upgrading portfolio, it still seems reasonable.
In the context of the gap between intermediate-term bonds and long-term bonds, things are considerably more extreme. Moving from intermediate-term to long-term, our risk (again, using duration) soars from 6.3 to 14.1, while our reward is paltry: the yield boost of +1.3% isn’t much better than the increase we got in moving from short- to intermediate-term!
Of course, the same recession argument can — and has — been made in favor of buying long-term bonds in anticipation of a future recession. The iShares 20+ Year Treasury Bond ETF (ticker: TLT) is probably the most popular vehicle for investors who want to include this type of “upside duration risk” in their portfolios. Investors buy TLT when they think rates will go down because the fund’s long duration promises to reward them if that outcome transpires.
Since August 2020 (when many interest rates bottomed), over $34 billion has poured into TLT, taking it from less than $10 billion in assets to over $43 billion. Over that same period, TLT’s price has plummeted -50%. This is a great example of SMI’s investing process keeping us safe (by steering us away from owning long-term bonds when many investors were piling into them), despite our view of a likely recession ahead, which would argue in favor of owning them.
These relative risk/reward relationships, as well as the recent traumatic experience of so many bond investors, show why intermediate-term bonds have earned the reputation as the sweet spot of the bond market. Given the dramatic rise in interest rates we’ve already experienced over the past three years, plus our expectation that slowing growth (and a possible recession) in the next few quarters will likely limit further increases in rates, we think continuing to own a blend of both short- and intermediate-term bonds makes a lot of sense today.
Conclusion
While our focus in this article has been primarily on using duration to gain insight into the potential risk that rising interest rates pose to bond funds, remember that duration also demonstrates the potential upside a fund has if interest rates decline. Duration simply demonstrates how much a fund is expected to move in the opposite direction of an interest-rate change. So if interest rates decline, these bond fund values would be expected to rise by roughly the amount of their duration.
This attractive potential is what has lured so many investors into TLT recently. We prefer to wait for clear evidence that rates have already turned durably lower before extending our durations, rather than trying to get in prior to such a turn.
To summarize, duration doesn’t take into account every factor that can affect bond performance, but it does offer an easy way to project the likely impact of interest-rate changes on various bond funds. Duration data for bond funds (supplied by Morningstar) can be found in the “Avg Duration” column in the bond section of SMI’s Fund Performance Rankings.
