Many DIY investors are not really comfortable with bonds and how they work. This is unfortunate because bonds are obviously an important component of the portfolio and become more important for most DIY investors as they age.How Bonds Work
Simply, bond prices and yields move in opposite directions. Because longer maturity bonds tend to have more future payments, their price tends to move around (i.e. is more volatile) more than shorter maturity bonds.
Total return over time includes the change in price plus the interest earned. Total returns for various maturity Treasury issues are shown in the graph (Click Graph to Enlarge)produced by Econompicdata . The bottom solid line is called the "yield curve". The yield curve is a snapshot at a point in time that shows the yields, by maturity, for a given class of bonds. For example, instead of Treasury issues, a yield curve could be drawn for single A corporate bonds. Typically, the curve slopes upward as shown in the graph. This reflects the greater volatility of longer maturity bonds. If the curve slopes downward, it is called an "inverted yield curve" and usually presages an economic downturn.
Year-to-date Results
The interesting part of the graph produced by Econompicdata is the returns by maturity. As a benchmark, the yield on the 10-year maturity U.S. Treasury note dropped from 3.84% to 2.70% for the period shown. This produced a total return in excess of 14% for the 10 year maturity - great offset to a weak stock market environment and definitely helpful for giving investors a good night's sleep. Notice that the longer maturity issues had greater return--that is, the more risk you took in the bond market, the greater the reward.
Kudos to Econompicdata for this chart.
If yields move from current levels back to a more normal 4%, investors are going to get smacked with some pretty good losses. At these interest rates, I'd be very careful investing in treasuries.
ReplyDeleteI agree fully, In fact the graph can give useful insights into the relative impact on various maturities of a rise in interest rates. The longer the maturity the greater the negative return when rates rise. In fact,now is probably a great time to move down the curve. For myself, I'm in 3-4 years corporates and feel like I'm watching the news and waiting on a hurricane to hit.
ReplyDeleteOh, to return to those halcyon days of the early 1980's when treasuries were 14% and to load up on long-term zero coupon bonds. Short term corporates seem to be the place to be. Are there any easy and cheap ways for the individual investor to short the long-term treasury market?
ReplyDeletePreviously, you have shown several examples with the general bond ETF AGG, which is performing pretty well right now. What do you feel the future holds for it and the municipals (i.e. MUB, PZA, TIF)?
ReplyDeletere: Jim To short bonds look at TBT. I'm not recommending it but it'll do what you want. Full disclosure: I have a position in it. You'll come across similar issues to pinpoint what you want to short.
ReplyDeletere: Shawn: For my clients I generally have half of their bond position in AGG. The rest is typically divided among JNK,CSJ and LQD. I don't like munis right now because I don't really follow that market. I put most of the bond funds in qualified accounts to avoid taxes.
Just a warning re: TBT and shorting Treasuries more broadly. If a bond is yielding 3.7% (the yield of a 30 year bond), then it will cost 3.7% to short it as you wait for yields to rise. For TBT (a double inverse fund) you pay 2x this yield (~7.4%) + fees (0.75%).
ReplyDeleteIn other words, over the next 12 months it will cost you more than 8% to short so you better be sure yields will rise before putting on this type of trade.
Re: Jake Good point. You just can't sit on it-there's a time element involved and the cost adds up.
ReplyDelete