It struck me as this post came to mind that most of what winds up on here on the “Hoosier Advisor” blog is another (very likely boring) bond dissertation. That was almost enough to keep me from proceeding with this snoozer, but those reactions were overridden by the need to contribute something to the dialogue of this worst start to a bond year in nearly a decade. 2013 was a doozy for bond owners, and this year is so far on pace to well outdo the “Taper Tantrum’s” damage to bond indices that year. 45 days or so is not enough to build a narrative on, but its enough that it should get our attention.
2020 YTD
2013 same period
Writing so much about bonds means a few things:
- Click counts will be few
- Regular readers fewer yet
- But, for those few remaining, I believe my voice can add value in this space
As the CIO for an RIA firm, my analytical duties are broad in nature: asset allocation, due diligence into alternatives, equity selection and more. But where those broad duties go deepest for me is in the management of our bond exposures. With a world so well populated with stock takes, I think I can fill in some gaps to help people out for bonds. I say that as much out of years of experience from being an early adopter of ETFs for fixed income as I do for anything out of skill. Also, I can rest reasonably assured that a Reddit mania will not come along and render these thoughts null and void.
Bond are largely mathematical beasts. Much of that has to do with the nature of simply being legal contracts with an expiration date. The issuer, or organization responsible for paying up to the terms of the contract carry many questions that are not simply mathematical. But bonds mostly move based on a series of math equations. So, back to the rough start to the year, one thing to understand is that if you are like the overwhelming majority and own your bonds through a fund that tracks the largest bond index – the Barclays Aggregate Bond Index – it is of the utmost importance to understand that your risks are higher than they were just a few short years ago.
The math can be intimidating, but for most the bigger hurdle is not the math; it is simply getting past the terminology. A lot of the math is complicated, but much of the big picture is straight forward. The big term for the risk experience so far this year is duration, which simply measures how sensitive bonds are to changes in interest rates. All the duration equation tells us is that if we wake up and interest rates are UP by X%…then (absent any other information) our bond would be DOWN by Y%. For stocks, we can have an idea of what a down market would mean for the stock, but the “absent other information” is often a moot point. “Additional information” for stocks will often dominate the day. But, for bonds, the math usually wins the day.
This relationship that sits underneath most days is on display for the chart below. Duration is measured in the lighter blue line and can be seen to be moving higher (6 on the right panel). Meanwhile, the darker blue line is measuring interest rates on the index and have been moving ever so lower. Together, they had been forming a toxic relationship of lower rates but with higher risks!
Take a quick glance at the charts above for AGG’s start to ’21 vs. ’13. What makes this year a worse start? Well, the math said it would be worse if rates went up. Rates have gone up a bit more this year, but the drop in prices to the AGG fund (and the universe pegged to it) has been more than double.
| 10 Year Rate | Price Drop | |
| ‘21 | +0.38 | -1.67% |
| ‘13 | +0.25 | -0.75% |
Keep in mind, small moves make all the difference for bonds. They are in the portfolio to provide ballast and security. So, these drops can be painful, and therefore, helpful if they can be mitigated.
One group in the crosshairs of this dynamic are lifecycle and target date funds. I believe most of my RIA peers abhor these funds, and for good reason and I mostly agree with those sentiments. But I save some room for the place they play in some 401k plans where participants lack access to an investment advisor (which is still shockingly high). But these lifecycle funds are loaded up on bonds that are indexed to the Barclays Agg AND have an investor base plowing money into the asset class as they age. The chart below depicts a range of allocation in the lifecycle fund industry, but across the board they are meant to lower equities and increase bonds as folks age.
The math was simply stacked against bond investors due to the underlying composition and levels of interest rates themselves. A recovering economy coupled, with the promise of massive fiscal stimulus lit the fuse to blow up the start for the year. If you are on your own with investing and have been in these crosshairs; as of the date of this publishing, I do not see any reason to panic or rush to get out of bonds. Bonds still play an important role – even if your access is limited to the big aggregate bond index. Even though our firm has had fewer bonds over the past several months for some of the reasons mentioned above, I would not make any blanket statement that fewer bonds themselves are in order. But it will still be time to pay very close attention as to how that exposure is garnered.
