The stock market is getting all of the headlines, but it’s the volatility in the bond market that is almost unprecedented. US Treasury rates sank to all-time lows last week with the 10-year Treasury note yield falling below 1% for the first time ever. It’s not just the direction yields are heading but the speed at which they are getting there. Interest rate volatility exploded, per the CBOE’s TYVIX, an index that measures 30-day volatility of U.S. 10-year Treasury Note futures prices:
What does this mean for bonds?
Bond prices are pricing in greater expected volatility than any time since 2009 right now. In other words, bond prices are either expected to keep going up a lot or experience a big pullback in the very near future. Recently, of course, it’s been a one-way move to the upside. In fact, Friday was the single greatest percentage gain in the history of TLT, per @iv_technicals:
Long-dated bond ETFs like TLT aren’t the only ones registering historic price gains. Lower duration ETFs like AGG and IEI are also both on pace for their best yearly performance since 2008. Perhaps the best example of just how much demand there has been for bonds comes from SHY, a 1-3 year treasury bond ETF. This would be considered one of the most conservative bond ETFs you could buy, and it’s already up 1.86% this year (including interest payments). For perspective, SHY’s annualized return since inception is 2%. So it’s nearly provided that return in the first 10 weeks of the year.
The bond volatility impact
All of this isn’t to say that bonds will surely move lower in price. However, their returns are less predictable now due to their current implied volatility. As a result, we can no longer make assumptions about the relative safety they’d typically provide in the way of lower volatility. And when we accept an instrument with high volatility, usually we assume we will get a potentially higher return. Right now, we are suspect of the returns bonds can provide versus the volatility risks they pose.
Because of this, we have been reducing some of the bond exposure in ETFs like TLT, SPTL, AGG, SCHR, and IEI, especially in non-taxable accounts. And we’ve been re-allocating those proceeds to ETFs like FLOT and SHYG.
FLOT is a very low volatility ETF and currently yields 1.90%. This makes it an ideal ETF to store profits from other areas of the bond market. For example, TLT is up 23.50% this year and the options market is pricing in a 14% range in the ETF between now and the end of the year. This implies the market expects TLT to finish the year somewhere between $143-$190. That equates to a year-to-date gain of 40% at the high end, but just 5.50% at the low end.
In other words, there are a lot more gains to potentially be given back than there are to be added to. Obviously, the options market’s estimated pricing is just that, an estimate. However, we tend to believe the options market is better at forecasting prices than we are. So we’d rather lock in the 23.50% gains and reduce some volatility exposure in the portfolio. And that’s where FLOT comes into play. Since the fund’s inception in 2011, the largest drawdown is just 0.52% from November-December 2018.
Critics would likely point to the fact that FLOT was not around in 2008, so there’s no way to know how it fared during the Great Financial Crisis. This is definitely a valid point and something we thought about ourselves. But, the drawdown in 2018 coincided with a nearly 20% drop in the S&P 500. Also, credit spreads were blowing out at the time. If FLOT was going to get whacked, that would have been a great time. The investment-grade credit rating and short-term nature of its debt likely contribute to its low volatility:
If FLOT is our low-risk replacement to volatile Treasury ETFs then SHYG is certainly our high-risk replacement. This is a short-term high yield corporate bond ETF, which we’ve written about before. SHYG is absolutely a high-risk bond instrument, as evidenced by its high correlation to equities, and nearly 3% drop in the last two weeks. But with higher risk comes a higher yield, and at 4.80%, we find SHYG attractive right here.
We mentioned earlier that expected volatility in government bond prices is making them riskier than usual right now. If we are taking an abnormal risk by holding government bonds, then why not just replace them with something that is typically riskier anyhow? That’s where SHYG comes into play for us. Furthermore, SHYG can also function as an equity replacement of sorts as well. Meaning, if someone is jittery about equity exposure, SHYG offers a lower-risk-than-equities way to put some relative risk on.
As a proxy for a worst-case scenario, we can look at HYG, which is a longer-dated, and slightly less junky version of SHYG. In the Great Financial Crisis, HYG fell 29%. A huge drop, yes, but still far less than the 50% drop endured in the S&P 500. Furthermore, running an Aladdin simulation by Blackrock estimates that a 50/50 portfolio of FLOT and SHYG would only decline 10% today in a similar 2008-like scenario:
Putting it to use
To be clear, long-dated bond ETFs like TLT and SPTL still warrant an allocation across our portfolios. But, if those allocations were previously at 6-9%, we’re likely adjusting them down to 3-6%. In balanced or conservative portfolios, we’re replacing that exposure with an increased allocation to FLOT. For instance, taking FLOT from a 2-5% allocation to a 5-8% allocation.
For those looking for greater risk and higher earning potential, we’re upping our allocation to SHYG. In those cases though, we are careful not to increase exposure to SHYG and equities together. It’s one or the other. This is because high yield ETFs like SHYG have a high correlation to equities and we are conscious not to replicate risk across asset classes.
Treasurys are pricing in greater volatility than at any other time since 2008-2009. So prices are expected to either keep rising sharply or experience a big drop. We don’t know which direction is more likely, but we know we don’t love high volatility coming from our “safe” bond allocations. That’s better reserved for riskier assets like high yield, preferred stocks, or equities.
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