I recently came across an article called “The bond market: Challenges ahead” on Vanguard’s website. The article shared some of Bill McNabb’s (Chairman and CEO of Vanguard) and Robert Auwaerter’s (head of Vanguard’s Fixed Income Group) thoughts on the bond market. There were a few things in the article that I found noteworthy and would like to share with readers.
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When responding to the question, “What’s your outlook for the broad U.S. bond market?” Bill McNabb had this to say:
“The one thing we can be fairly confident about is that the next ten years of bond returns aren’t going to be what the last ten years have been, when the broad bond market returned about 5% a year. It’s almost mathematically impossible because yields currently are so low.”
Despite yields being so low, I think whether the next ten years of bond returns are like the last ten depends on how a bond investor defines his or her returns and the construction of that investor’s portfolio. In the world of stocks, a stock may go down and never return to the level at which it was purchased. When owning a non-defined-maturity bond fund, the same thing can happen. If those investors are interested in tracking total returns, they should do so on a mark-to-market basis. Individual bond investors, however, might view “returns” in a different way.
In my portfolio, I own the individual bonds of numerous companies. I have planned my income needs in a way that I am quite confident I will never be forced to sell one of those bonds to pay the bills. Therefore, I intend to hold each bond to maturity. I may change my mind in the future, but when I first purchase an individual bond, my intention is to hold it to maturity. The mark-to-market changes are irrelevant to me. From time to time, I do take advantage of the opportunity to lock in gains on a bond and roll the original investment into a different security. But should unfavorable mark-to-market movements occur in the portfolio, it is no big deal. I simply hold on to the security and can wait for maturity to get my original investment back.
Given this, I view my returns on individual bonds as the annual yield I collect on a position plus any realized gains or losses I may decide to take in the future. Unrealized gains and losses are irrelevant when the bond (absent a default) is guaranteed to one day return to par. With that in mind, if someone owned a 20-year individual bond 10 years ago and still holds that bond today, then the returns that person realizes over the next 10 years will keep up with the last 10 years’ worth of returns.
McNabb also had this to say regarding investors putting money into bond funds even as yields have declined:
“In a sense, it’s not surprising how much money has flowed into bond funds. Investors tend to focus on recent past performance . . . So investors’ behavior is understandable, but there are significant risks to chasing past performance.”
While equity investors may be known for chasing performance, I am not convinced that the reason for bond flows being so strong despite falling yields is due to performance chasing. Instead, there may be other factors at work:
- Matching income to liabilities – As Sergio Trigo Paz, Managing Director and Head of BlackRock’s Emerging Markets Fixed Income within the Portfolio Management Group, recently said, he was having conversations with investors who were matching cash flows from bonds to liabilities. When yields decline and investors are trying to meet certain liabilities with a bond portfolio, they have to purchase more. It doesn’t mean you are chasing returns. Instead, it is simply indicative of trying to meet your goals in a low yield environment.
- It is possible that investors are investing in bonds because they are fearful of stocks.
- Perhaps investors are searching for financial instruments they believe will have lower volatility going forward and are deciding that bonds are that asset class.
- Some investors might view the current corporate bond market spreads as high enough to provide some cushion should benchmark Treasury yields rise. If one makes a bond purchase because he or she views spreads as attractive, that is quite different from chasing historical returns.
- Other investors might be making a statement about their expectations for future U.S. economic growth and their future inflation expectations when purchasing bonds in a declining yield environment.
- It is also possible that some investors are putting money into fixed income securities, despite low yields, because they are following standard asset allocation models they’ve been taught (or told) to follow. After all, we are in our fifth year of an unconventional monetary policy that happens to correspond with tens of millions of baby boomers also getting closer to retirement. An aging population could certainly be contributing to the consistent inflows into bonds.
- Perhaps other investors are simply front running what they expect to be a never-ending cycle of bond purchases by the Federal Reserve.
To state that investors are chasing performance in an asset class that people typically hold for income and safety doesn’t seem quite right to me. I am sure if we asked around enough, we could find a few people doing so. But all in all, I would give more credence to some combination of the many reasons I listed above for the consistent inflows into bonds.
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