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Oct 12

Understanding Bond Returns

by Ethan Gilbert

We had several clients this year reach out to ask how bonds were performing in their portfolios. These are great questions, so we created a few items to address what you see in your statements.  Some people notice they have held bonds for several years but seem to have a loss with their holding. This may come from their monthly statement from the custodian. Below is an example of how that looks:

From looking at this statement, it seems this investor has lost almost $9,000 from their bond holdings in the last 2.5 years (1/25/16 to 7/31/18). However, if you look at the returns from the bond funds over that period you see they were positive.

This is possible because the bond funds pay interest every month. That interest goes into the account as a monthly cash deposit and is used when we rebalance the portfolio. Interest paid in cash does not increase the market value column. Despite showing an unrealized loss, the investor did make money through these holdings.

All that said, bonds can lose money. When interest rates rise, the value of existing bonds goes down, and returns can be negative even when accounting for interest payments.

Real life application of interest rates:
  1. How it’s playing out this year (numbers from 1/1/2018 to 9/26/2018):An aggregate bond fund holds thousands of bonds. In their entirety, they have an average weighted life (duration) of 6 years. This number tells us how sensitive they are to interest rate changes.At the start of the year, an aggregate bond fund was yielding 2.57%. It is now yielding 3.22%. That means it had an interest rate increase of 0.65%. If you multiply that increase by the bond duration, you get the change in value of the underlying bonds. In this case, 6 x 0.65% = 3.90%, so the bonds’ market value dropped by 3.90% from January through September 2018.However, the bonds are paying interest. If you average the yield at the start of the year and currently, you get 2.90%. For roughly 9 months in the year, 2.90% x 9 / 12 = 2.13% of earned interest. This nets out to a loss of 1.77% so far this year.
  2. This isn’t a bad thing! Rising interest rates generally aren’t a problem for the following reasons:
    1. Your returns going forward will be higher! If bond yields start at 2.57% and never change, you’ll earn 2.57% for the rest of your life. If they start at 2.57%, jump to 3.22% and then never change you’ll eventually have more money because of it. Remember, the 3.90% drop in principal came because yields went up 0.65%. Every year from now on you’ll be getting 0.65% more in return. 3.90% / 0.65% = 6. In six years, you’ll have made up the lost principal in extra interest. From that point on you’ll be getting more in yield, leaving you better off in the long run!
    2. Usually, bonds and stocks have an inverse relationship. Historically, the price of stocks and bonds move inversely with each other. This means when stocks are falling, interest rates go down and the value of existing bonds goes up. The opposite is true as well; if the economy is doing well and stocks are rising, interest rates are also going up and the value of existing bonds goes down. Quantitative easing by the Federal Reserve has skewed this some, but overtime we expect this to continue. For a balanced investor who holds both stocks and bonds – when bonds are losing value for an extended period, the stock portion of the portfolio is likely going up. Remember, a few months, quarters or even years is a relatively short time when it comes to investing. And for most of our clients, our time horizon is decades not years.

In summary, we feel bonds add value to most individuals’ portfolios. Over the long run they provide a positive return and have much less volatility than stocks. Additionally, they usually move in the opposite direction of stocks which limits large fluctuations in portfolio value and amplifies the benefit of rebalancing.

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