Cash Is Not Enough: Why Hold Bond ETFs Despite Price Rollercoasters. (2024)

Welcome to Part 3 of our Definitive Guide to Bond Index Investing.

Everyone has an idea about how the stock market works, yet bond markets are widely misunderstood. Retail investors often label them as ‘uninteresting’—to put it mildly. However, bonds play an important role in the overall success of your investment strategy.

In 2024, not only do they offer a juicy yield, but they may also act as a powerful weapon in your portfolio. Consider this:

In June 2007, the 10-year US Treasury yield stood at 5%. Over the following 18 months, the S&P 500 lost almost 40%. Yet, US bonds returned 12%. During the Dot Com crash, US bonds returned 34% over three years, starting with a yield of only 6.5%. How was this possible?

Today, let’s explore a simplified Bond ETF calculator to get an intuitive sense of the upside and downside of Bond ETFs, and why keeping cash may not always be preferable.

• How much can I lose by holding Bonds ETFs versus Cash?
• Are Bond ETF losses from rising interest rates temporary?
• If so, when will coupons offset any price losses for my Bond ETF?
• In the current yield environment, what is the appeal of Bond ETFs?

There are also fundamental reasons why Bond analysts usually sound smarter than Equity analysts.One of them being, Bond language is geeky.But I think the Pareto Principle, aka the 80/20 rule also holds for Bond ETFs.

Grasping just two concepts, Yield and Duration, will help youunderstand 80% of what matters in selecting the right Government Bond ETFs.

I let the 20% including all the jargon, with lower impact, aside. Ignoring it and setting some simplified assumptions can you help explain Bond ETFs to aGolden Retriever. In summary, when choosing a Government Bond ETF, consider its Risk and its Return:

• The Yield-to-Maturity(YTM) is the Return you can expect.
• The Duration is the Risk you take.

What Return Can I expect from Bond ETFs?

You see, this is the main one misconception.Because you are used to looking at historical Equity ETF and Stock prices, you also check them for Bond ETFs.Yes, for Equity, historical prices give you an indication of how bumpy the road ahead may be.And what returns you may expect in the long run.

But here is something that may sound unintuitive. For bonds, historical prices do not matter.

Apart from showing you that yields were going down over the past few decades, but you already knew that, they are relatively useless.On a Bloomberg Terminal there is a YAS Screen, or short for Yield and Spread Analysis, which serves as base for traders to calculate yields.

Professional investors almost never quote a dollar price when they trade bonds. They quote a yield.

And it gets even more interesting.While forEquities the future is largely unknown, forBonds despite all their quirkiness thefuture returns are largely known. After all, the products are called Fixed Income.As Jack Bogle noted, since 1926, the initial yield on the 10-year Treasury explains 92% of the total return an investor would have earned over the subsequent decade.

But there is an important condition. You need to hold themto maturity.

That’s because, in theshort term,Bondpricescanmove drastically.For Investment Banks, trading Bonds, in the short term, can be a lucrative business.

Equities in Dallas became training program shorthand for 'Just bury that lowest form of human scum where it will never be seen again'

- Michael Lews, Liar's Poker

You may not know that since the 1980s,trading Bonds on Wall Street became more sexy than trading Equities.In his book, Liar’s Poker,Michael Lewisdescribes Salomon Brothers’ training program for new hires back in those days.

“After the end of the program, the new analysts are placed into various divisions of the firm, with the most coveted desk being the mortgage bond desk and the least desirable one being Equities”.

Want to travel back in time? Here is the Goldman Sachs Fixed Income Recruiting Video from 1985!

Issuing and trading non-government bonds (e.g. Mortgage Bonds) was the most lucrative part of all of them. But again, exciting as non-government bonds may be, they merit a separate article.

While Investment Banks think short term when trading bonds, for you – a long-term investor – regardless of the fluctuation, holding them to maturity locks-in the initial Yield. No matter how high rates rise between the time you invest and maturity, theBond price will be, so to speak, ‘pulled to par’.

This pull means it will end up being the initial or close to the initial price (if issued above/below par) as the time to maturity gets closer.

What are the Temporary Risks?

Now you know that Bond prices almost never matter.What if I told you that you can also ignore looking at coupon types, coupon rates or even Bond maturity dates?

In fact, all those metrics can be aggregated up in order to compare the risk for different Bond ETFs.The essence of Bond Risk is thencaptured in one metric. Duration.

Duration is the risk of holding Bonds in a rising yield environment.

Why? Think of it as like an opportunity cost. If your ETF holds longer bonds, with a fixed coupon, they rapidly become less attractive if new, higher-yielding Bonds, are issued. The price of the ETF needs to adjust to reflect that so that investors earn the same YTM.

So, if rates rise by 1%, your 8-year duration Bond ETF will drop by 8%.

How long before you recover those temporary losses?For Bond ETFs you sometimes need to be patient.

In a rising yield environment, you are protected if you hold the Bond ETF for a period up to 2x duration,in years.

This time can be shorter. It does matter when rates stop rising. That’s why we created the Bond ETF calculator.

In a pessimistic scenario, over a 2x duration period, the increased rates dragging the ETF price down will be fully offset by newly issued bonds’ higher coupons.In a nutshell, the longer the duration of the ETF, the more pain you have to endure. This is because you are taking more risk and earning potentially more return.

There are a number of Bond ETFs categories:

• Money Market Funds are the shortest, below 1 year.
• Short-term Bond ETFs are usually defined as below 5 years.
• Currently, most Government or Aggregate Bond ETFs have a duration of 6 to 9 years.
• But some, like US iShares TLT are longer, at about 18 years.

Physical Cash, by definition, has a duration and yield of 0. No risk, no return.

Now, here is the interesting part for Equity investors.

Is there any possible, unexpected, upside opportunity of Bond ETFs? Yes, it’s the other side of the coin. Since bonds decrease temporarily in price, they can also go up.

While holding Bond ETFs during the investment horizon is the goal as part of your portfolio allocation, rebalancing is probably the only thing you need to do with your portfolio over that investing horizon.

The upside comes precisely from the fact thatyou won’t hold all of your Bond ETFs for the length of your investment horizon.Selling during a crisis means that, you may end up earning more than Yield to maturity on some of your Bond ETFs.

Remember in certain recessionary scenarios, as yields fall, Bond ETF prices will rise. Whilethe long term yield is known, short term returns can be higher than expected. That’s because investors rush into in-demand safe-haven assets during a crisis.

And you benefit from this opportunity.This usually happens at the exact same time as Equity prices in your portfolio fall.

Bond ETFs will become atoo large part of your portfolio, andyou are likely to sell them, exactly at a time when they increase in value.

This ‘price pop’ is directly related to the ETF duration. The higher the duration, the better the protection.And sometimes even more.

You can use that increase in price to sell Bond ETFs andbuy cheaper Equities during a market crash. It’s part of a proper preparation to benefiting from the next recession.That’s why it’s key to compare yields for a certain duration. It’s the return you get for the risk you take.

Using the Bond ETF Calculator, let’s simulate the following scenario for iShares IEF Bond ETF:

1. Starting yield to maturity of the ETF is 0.75%
2. Rates rise over 2 years at a rate of 2% per annum
3. After 3 years a recession forces the Central Bank to lower rates to 1%

The first 6 months actually happened, so it can serve to back-test how the calculator simulates reality:

• After 6 months, the ETF price dropped from 121.67 to 113.0. We also need to add the dividends that the ETF paid (since it’s a distributing ETF) of 0.39 giving a total return equivalent price of 113.4 (ignoring interest on interest for sake of simplicity, given it’s a short time horizon)
• The calculator price after six month is 113.0 (the calculator takes a total return price approach)
• The calculator captured approx. 90% of the actual price behavior despite its limitations and potential issues with exact market prices.

In my illustrative scenario, investors will have endure more losses. In fact, the price will drop further and bottom out at 96.8.

Central Bank action provides a simplified ‘pop’ effect on the price that jumps to 126 after 3 years, with a 3-year annualized return of 1.2% – above the initial Yield to Maturity of 0.75%.

The positive shock is very significant since rates drop by 4% which would take some time in reality. It illustrates the concept, though. Also, Central Banks are becoming more aggressive in their stimulus with each crisis.

But what is the absolute worst case (if we also turn off the Last Year of Rate hike)?

The investor achieves a Yield to maturity after 16 years (2x duration) – this scenario of interest rates increasing without break seems rather absurd, but illustrates how the rule works.

Hence, in practice the yield to maturity is achieved much earlier.

Here is the beta version of the calculator. Test it out for your preferred Bond ETF and let me know what you think.

Next Steps

Now that you have a grasp of the duration aspect, let’s have a look at other characteristics of Bond ETFs, that are important for a Long Term Investor.

PART 2 - Key Bond ETF Types

PART 4 - High Quality Bond ETFs - How To choose?