Falling Bond Prices’ Sweet Upside for Investors

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Federal Reserve Chairman Jerome Powell.

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Jim Watson/AFP via Getty Images

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It is with no small measure of bemusement that veteran investors read or hear pronouncements about “new records” or “unpreceded,” based on history covering a digital database of just a few decades, which may also exceed the time on earth of the person asserting such an absolute.

For that reason and others, it is always worthwhile to catch up with Dan Fuss, the 88-year-old vice chairman of Loomis Sayles. While he’s stepped back from day-to-day fund-portfolio management, he continues to impart wisdom accumulated over six-plus decades in the credit markets.

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Reached by telephone this past week, Fuss sees direct parallels to the 1960s, back when bond yields were calculated using something called a “basis book,” which resembled another anachronism, the telephone directory. In those Dark Ages, yields were moving ever higher, pushing down bond prices to discounts.

That meant mark-to-market losses, but the climbing yields improved the reinvestment returns on a bond portfolio. In other words, the interest on interest would compound at rising rates; over time, that is an important, but underappreciated, source of fixed-income return.

The challenge, Fuss observes, is to limit the bond price losses while the reinvestment rate rises. That means shortening maturities. Buying relatively short to intermediate bonds whose prices have fallenlets an investor remain defensive in a rising-yield environment, while prices of those discounted bonds eventually move back to par as they approach maturity.

Note that this is the complete opposite tack from what worked in the four-decade bond bull market. Locking in the longest duration paid off best as long-term Treasury bond yields went on a long march down, from 15% in 1981 to 1% in 2020.

That era is arguably over, and a playbook that predates it would now seem more appropriate. Staying short and defensive is now the better strategy. Until recently, however, that would have meant earning yields barely above zero. But short to intermediate bond yields have risen appreciably, and prices have fallen concomitantly, as the market has priced in the anticipated federal-funds interest-rate hikes by the Federal Reserve.

While the Fed has boosted its key policy rates twice, by a total of 75 basis points, to 0.75%-1%, the Treasury two-year note’s yield has climbed from about 0.20% a year ago to 2.52% as of Thursday. (A basis point is 1/100th of a percentage point.) The two-year is the Treasury maturity most sensitive to expected Fed actions. Its yield reflects the anticipated year-end target range of 2.50%-2.75% priced in the fed-funds futures market, according to CME FedWatch,

As a practical matter, that means an investor can garner a real yield relative to anticipated inflation with limited risk, something impossible until recently without resorting to securities with credit risk. Prices of various short-term bond exchange-traded funds have slid substantially, lifting their 30-day SEC yields far above the rates paid on money-market funds or “high-yield” savings accounts (the best of which pay just 0.60% with no boost since the Fed’s 50-basis-point rate hike on May 4). In addition, these short-term ETFs’ yields are competitive with those on longer-term funds, but with about half the interest-rate risk.

For instance, iShares 1-3 Year Treasury Bond (ticker: SHY) has an SEC yield of 2.40%, with an effective duration of just 1.88 years. (Duration measures a bond portfolio’s sensitivity to yield changes.) That attractive valuation reflects a 2.4% price decline from the high at the start of the year, a rather painful adjustment for what’s supposed to be an ultra-defensive holding.

For slightly more risk, iShares Core 1-5 Year USD Bond (ISTB) offers an SEC yield of 3.17%, with a duration of 2.80 years—a product of a 4.9% price decline from its January high. The ETF provides a higher yield than the 2.93% of iShares Core US Aggregate Bond (AGG), which has a twice-as-long duration of 6.52 years.

Other points of comparison: iShares Core 1-5 Year USD Bond actually manages a real yield above the 2.70% 10-year break-even inflation rate derived from the Treasury inflation-protected securities, or TIPS, market (although far short of the 8.3 % rise in the consumer price index from a year ago). The rise in yields also obviates the income portion of the TINA (There Is No Alternative) justification for stocks; the SPDR S&P 500 Trust‘s
(SPY) yield, once higher than most bond benchmarks’, now trails them at 1.45%.

The municipal bond market also has had a wrenching readjustment that’s produced more attractive valuations. According to Bespoke Investment Group, the decline in the ICE Bank of America Municipal Bond Index of 10.26% since late July is comparable to routs of 11.38% in the March 2020 Covid crisis, 12.29% in October 2008 during the financial crisis, and 10.09% in November 1994, when the Fed previously was hiking rates in rapid fashion.

As noted here a month ago, that painful readjustment has made for much more attractive yields. But investors don’t have to extend far out to garner most of them.

The SPDR Nuveen Bloomberg Short Term Municipal Bond ETF (SHM) has an SEC yield of 2.15%, with a duration of 2.73 years. That compares with 2.81% for iShares National Muni Bond (MUB), with a duration of 6.75 years. In other words, the shorter muni ETF provides 76.5% of the yield with 40.4% of the interest-rate risk of its longer counterpart.

Until recently, investors faced a Hobson’s choice: Accept the volatility of equities, the return-free risk of bonds, or zero yields on cash. Short-term bonds now provide nearly the same yield as longer maturities with less risk, offering a way to help ride out the current bear market in stocks.

Write to Randall W. Forsyth at [email protected]

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Credit: www.marketwatch.com /

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