Bond have fallen -6.97%[1] in the first quarter of 2022 in response to rising interest rates. If you need to sell your bond portfolio right away this is obviously not great news but if you are investing for retirement or in retirement, this is cause for optimism. With recent rises in interest rates, and more on the way, it makes senses that rising rates will feed through to higher payments from bonds. How we get from here (falling bond prices) to there (higher income for bond holders) requires an understanding of bond prices, bond returns and the impact of interest rates.
Imagine you own a bond that pays 3% over 10 years. Let’s say you bought it recently for $100. If left alone the bond would pay $3 (the coupon) every year for ten years. After ten years the bond matures, and you get the maturity value of $100. Your annual return is 3% as all the return comes from the bond coupon and it matures at the same value as you paid for it. So far, so simple.
Suppose you could have bought a similar bond paying 4%. You would make an additional return if you could purchase it for the same price, you and other investors would be flocking to the higher yielding bond and selling lower yielding bonds. The laws of supply and demand requires the price of the higher yielding bond rises relative to the price of the lower yielding bond. In our example the price of the bond paying 3% would need to fall to $92 to give the same return as the bond paying 4%. Your bond paying 3% falls in price, but the bond still matures at $100, so you get a capital gain of $8 at maturity. The total return from the bond then consists of two components: the coupon paid and the difference between the market price and the maturity value (usually pegged at $100). It is tempting to fixate on the near-term price decline and ignore the future capital gain. You might be tempted to sell your bonds even though you had intended to hold them for the long term. A price decline is not the same as losing money unless you sell the bond. In this regard, bonds are unlike stocks because the bond matures and the price at maturity is known in advance.
Because we know the maturity value of the bond we can calculate a useful quantity, the yield to maturity (YTM). The YTM is the discount rate that equates the present value of a bond’s cash flows with its market price (including accrued interest). In other words, YTM is the bond return including coupon payments and any difference between the current price and the maturity value. As interest rates rise then current bond prices fall but the YTM rises. If the price decline is offset by higher future returns how long before the higher coupons and capital gain at maturity offsets the price decline?
We consider two bond ETFs, both from iShares (Blackrock). Bond ETFs are simply a basket of individual bonds so the ETFS price movement and coupon reflects a overall performance of the individual bonds. XSB is a short-term bond ETF with an average bond maturity of 2.99 years, and XBB covers the Canadian bond universe of short, medium, and long-term bonds and has an average bond maturity of 10.4 years. Both consist of only investment grade bonds.
The YTM has risen steeply in recent months as illustrated below.
The break-even point is measured by the bond ETF duration which is published by Blackrock. The duration for XSB is 2.65 years and the duration for XBB is 7.55 years (as of 22 April 2022). Investors in these ETFs expect to benefit from rising interest rates if they retain their investments for longer than the duration. As with any statement about the future, this should be considered only an estimate and is influenced by a range of factors.
We focus on bond ETFs because they are a very cost-effective way of accessing the bond market for retail investors. While individual bonds have a maturity date, bond ETFs do not. In a bond ETF individual bonds mature and the proceeds are re-invested in new bonds, so they track the underlying bond index closely. XBB, for example, holds 1453 individual bonds, greatly reducing the risk of default.
If rising rates are destined to continue for a while why not get out of the bond market to avoid future price declines and buy back in when the market has stabilized at a higher interest rate? Unfortunately, the bond market is no different from the stock market in that it rapidly incorporates available information into current prices. Current bonds prices reflect not only rate changes that have occurred but future interest rate changes that are expected.
There is always the potential for the unexpected but making money out of unexpected changes in bond prices where near term interest rates are signaled in advance by central banks and bonds are considerably less volatile than stocks is a challenge. Standard and Poors reviewed the performance of US bond managers and compared their returns with a benchmark based on holding bonds through to maturity. Over the past fifteen years 95% of funds in a similar category as XBB underperformed their benchmark. For shorter term bond funds, comparable to XSB, the figure was 100%.
In conclusion investors should focus on what they can control:
Avoid timing the bond market by anticipating unexpected changes – it is at least as difficult as timing the stock market.
[1] FTSE Canada Universe Bond Index
[2] The total return also includes a small contribution relating to how duration changes with interest rates, which we ignore.
