Bonds combine characteristics that uniquely qualify them as a portfolio component: Negative correlation to the stock market, relatively low volatility, and a positive carry. Consequently, it is no surprise that bonds are an essential part of many portfolios, including the ubiquitous 60/40 portfolio. But in the light of historically low yields and the outlook of the Federal Reserve raising yields possibly as soon as late 2021, we have to wonder if bonds continue to play this role moving forward. Accordingly, this article takes a closer look at bonds in a rising yield environment and the implications on investment portfolios.
Bond Yields Declined Since 1984
Bond yields have been declining for decades. However, it might not be obvious why this was a good thing for investors. Bonds are typically considered fixed-income investments. This characterization implies that declining yields are bad because it reduces the interest paid by the bonds. However, this is not entirely true. Bond valuation formulas dictate that prices of existing bonds must go up when the yields of newly issued bonds decline. Therefore, investors reap capital gains on the bonds they already hold in return for lower interest payments on bonds they buy moving forward.
To find a period of continually rising bonds yields, we must go far back. Bond yields peaked in September 1981 at about 15.8% and have been steadily declining since June 1984. Consequently, we need to go even further back if we want to learn something about environments of rising yields. For this article, we have chosen to go back to January 1968. That gives us 13 years of rising yields, plus another three years with a sharp decline followed by an almost equally swift recovery of bond yields.
How To Backfill ETF Quotes
But going back that far is easier said than done. Back in 1968, we did not have convenient ETFs tracking bond investments with various maturities. Even mutual funds didn't exist back then; Vanguard's VUSTX has an inception date of May 1986. In consequence, we cannot simply backfill the missing ETF data with mutual funds. However, there is a workaround: we have historical yield data for U.S. Treasuries reaching back into the 1960s, and we can use these to synthesize bond prices using bond valuation formulas. We can then backfill our ETF quotes with these synthetic data by splicing the two together.
The chart above shows our model to backfill iShares' TLT. As you can see, our model quite accurately tracks the performance of the ETF. We are therefore confident that this method leads to valuable insights. We repeated the same process for TLH, IEF, and IEI, covering maturities from three to 20+ years.
Treasury Returns since 1968
We have seen above that declining yields lead to capital gains, especially with longer-term maturities. Unfortunately, the opposite is also true. For example, between 1968 and 1981, the 10-Year Treasury yield rose from 5.5% to 15.8%, and we would expect that Treasury bonds were a terrible investment in that period.
When comparing the cumulative returns of Treasuries of various maturities, we can see that between 1968 and 1984, the 20+ Year bonds clearly trail the returns of bonds with shorter maturities while outperforming them in later years. And over the past 54 years, all maturities ultimately led to quite similar results. However, their path has been different, and longer-term bonds showed deeper drawdowns and often slower recovery than their shorter-term cousins.
It is worth noting here that the higher volatility of longer-term bonds may be desirable under certain circumstances. For example, if these bonds are used in a portfolio that also invests in stocks, the two partially counteract each other because of the negative correlation between stocks and Treasury bonds, overall dampening portfolio volatility.
Graphing the 12-months rolling returns for the various bond maturities leads to a busy chart and further insights:
- 12-months rolling returns of short-term bonds rarely turn negative. This statement is true for all periods, including the environment of rising yields between 1968 and 1981.
- Rolling returns of long-term bonds move more violently but typically recover within a couple of years. But, again, this behavior explicitly includes the period of rising yields before 1981.
In summary, rolling returns before 1981 are not that different from returns in later years. Instead, there is constant fluctuation with primary cycles of 6-months to 2-years length. And in the spirit of TuringTrader.com, these fluctuating returns can be seen as a trading opportunity!
A Trading Strategy for U.S. Treasuries
With the findings above, we can formulate a simple strategy to trade U.S. Treasuries:
- Determine the trend of Treasury yields. As a representative of Treasury yields, we use the Market Yield on U.S. Treasury Securities at 10-Year Constant Maturity.
- If yields are rising, invest in Treasuries with 3-7 years remaining maturity: IEI
- If yields are falling, invest in Treasuries with 20+ years remaining maturity: TLT
The chart shows that this method is far from perfect. Occasionally, when the yield regime switches at low volatility, our simple mechanism ends up on the wrong side of the trade for longer than we would like. Nonetheless, it seems right more often than wrong.
What stands out here is that we can find environments of rising and falling yields on much shorter time frames than initially anticipated. This is good news because our strategy now has many more decision points, increasing our confidence in its validity.
The rolling returns show that this simple method continually beats its equal-weighted benchmark (50% IEF + 50% TLT) over the past 54 years. Oftentimes, our strategy manages to deliever higher returns and avoid dipping into negative territory. This is a great result!
Finally, we get to look at the equity curve of this trading strategy for U.S. Treasuries and draw conclusions:
U.S. Treasuries have mostly positive returns, even in times of rising yields. This is a significant finding. It should relieve investors of the fear of seeing their portfolios crashing down when the Fed finally starts increasing bond yields. While returns will suffer for a while, higher yields should compensate for possible capital losses in the longer term.
Bond maturity is less critical than assumed. Our experiment above shows that adjusting bond maturity based on the current yield trends can improve returns. However, our research also indicates that the improvements are relatively small. In our experiment, we have been able to squeeze another 1.8% return out of U.S. Treasuries. This result does not seem enough to justify the additional effort.
Cumulative returns of U.S. Treasuries may plateau for a while, especially for longer maturities. We have observed this effect throughout the past 54 years, but it seems more prominent in recent times. Occasionally, growth will stall for a couple of years, and investors should prepare for this. One way to do so is to make sure portfolios also include other asset classes, e.g., corporate bonds, junk bonds, or convertible bonds, to prop up returns. ETFs representing these asset classes include iShares' LQD, iShares' HYG, and State Street's CWB.
U.S. Treasuries continue to be a valuable hedge for the stock market. However, despite low yields, U.S. Treasuries negatively correlate to the U.S. stock market. This behavior is owed to the Flight-to-quality effect, which leads to investors piling into safer asset classes in times of crisis. And while other asset classes, e.g., VIX futures like Barclays' VXX, have higher hedging capabilities, these products typically have a negative carry, making market timing very critical. In contrast, U.S. Treasuries have a positive carry, which makes them much easier to handle.
Our Bonds-NOT portfolio aligns well with these findings. It combines fixed income securities of various quality and maturity with small holdings in gold and stock market indices. We currently believe that this Bonds-NOT will continue to work moving forward, and add value to a portfolio by acting as as a hedge.
In late 2021, we are anticipating the Fed to start tapering its bond purchases soon. Accordingly, we will carefully observe the portfolio's performance and make adjustments if we feel these are required.