The bond market has had a great first half of 2019, generating returns well above their historical averages. We don’t know what will happen next in the bond market. But we do think it’s wise to put year-to-date returns in their historical context. Doing so can help us evaluate if certain segments of the bond market still align with our investment objectives.
Why we invest in the bond market
We invest in bonds for two primary reasons: 1) monthly interest income and 2) lower volatility relative to stocks. To gain exposure to the bond market, we generally invest in bond ETFs. The first thing most bond investors look at is the yield a specific bond ETF generates. That is, how much interest will it pay out over the course of the year. With bond ETFs, this yield is then divided by 12 and distributed monthly. For example, a bond ETF yielding 3%, will pay 0.25% per month for 12 months. Therefore, if you invest $50,000 in this type of bond ETF, you can expect $125 in interest each month ($50,000 x 0.25%).
3 popular bond ETFs we invest in
Here are 3 bond ETFs we’ve invested in since the beginning of 2019 (yield):
AGG (2.5%) – Core aggregate bond: this ETF is mostly made up of treasury bills, mortgage-backed-securities (MBS), and investment grade corporate debt.
LQD (3.27%) – Investment grade corporate bond: this ETF is made up of investment grade corporate debt.
PCY (4.94%) – Emerging markets sovereign debt: This ETF is made up of debt from emerging market governments such as those in South America, the Middle East, and Asia.
Understand yield vs price performance
When buying any of these ETFs, we can start a projected 12-month return with the yield shown. Obviously, bond prices can move up or down and this impacts our return as well. But the price of the bond ETF would need to decline by greater than the yield before our total return is negative. For example, if we invest in LQD and the price drops 1.25% over 12 months, we still generated roughly a 2% return (3.27% yield – 1.25% price drop). The opposite can happen as well: bond prices can rise, and add to the total return. For example, if LQD were to rise 2% on the year, your total return is now 5.27% (3.27% yield + 2% price rise).
Can the bond market stay hot?
In 2019, bond prices have been rising significantly. This means total returns for AGG, LQD, and PCY are benefiting from yield and excellent price performance. Look at these year-to-date returns for the 3 ETF’s mentioned earlier:
|ETF Ticker||Year-to date return||Yield|
Notice how much greater the year-to-date returns are vs the yield on each ETF? In the case of AGG, the return is nearly double the yield. For LQD the return is more than triple the yield. And for PCY, the return is more than double the yield. In other words, any investors who bought these for yield has been gift-wrapped amazing price performance as well. Keep in mind, the yield is for 12 months, and the year-to-date return only accounts for the first 6 months of the year. If we looked at the year-to-date returns vs the real 6-month yield, the numbers would highlight even greater price performance.
Bond performance in historical context
Now, consider these returns relative to their historical returns since the ETFs were first available for trading:
|ETF Ticker||Annualized Return (since inception)||Difference in YTD return vs inception return|
As you can see, the ETFs have outperformed their historical annualized return by a meaningful amount. In the case of LQD and PCY, the current year-to-date returns are roughly double the historical annualized return. These returns far exceed average annual returns, let alone for the first 6 months of a year. We’d consider it unfair to expect the bond market to keep delivering such excellent returns for the rest of the year.
Sell bonds and go where?
The purpose of this article isn’t to say that you should sell bonds. However, now is a good time to evaluate your bond portfolio and see if you should make any adjustments. For example, some investors may want to consider reducing exposure to LQD in favor of AGG. That’s just one idea, if you’re looking for more, be on the look out for our upcoming article: 3 adjustments we’re making to our bond portfolios right now.
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