Even if you think we’re headed into an extended period of 1970s-like stagflation, you should stick with your bondholdings.
This advice seems ludicrous to many. Interest rates skyrocketed in that stagflation era, and everyone “knows” that rising rates are bad for bonds. From 1966 to 1981, for example, the 10-year Treasury yield rose from below 5% to nearly 15%.
Read: Is it better to buy bonds or bond funds? It depends how hard you are willing to work.
To borrow from the title of Joseph Nguyen’s book, however, “don’t believe everything you think.” A portfolio of intermediate Treasurys over this 15-year period produced an annualized total return of 7.0%, according to data from Ibbotson (now part of Morningstar). It even beat inflation over this period.
How can this be? The answer traces to the mechanics of what’s known as a bond ladder, which is a portfolio of bonds that is managed to maintain a constant duration. (A bond’s duration reflects the gain or loss it will suffer from a one-percentage-point change in yield.) Most bond mutual funds and ETFs employ ladders, which means they reinvest in longer-dated bonds the proceeds of ones that have matured—thereby maintaining the average duration of the bonds they own.
Research has shown that in a rising rate environment, the higher yields of newly purchased bonds eventually make up for the capital losses incurred by previously owned bonds. That, in turn, means that the long-term return of a bond index fund that maintains a constant duration will be close to its initial yield. The required length of time you must hold the bond-ladder-employing fund is a function of its duration: You must hold it for at least one year less than twice its duration target.
(The researchers who derived this formula are Martin Leibowitz and Anthony Bova, managing director and executive director at Morgan Stanley, respectively, and Stanley Kogelman, a principal at New York-based investment-advisory firm Advanced Portfolio Management. They show how they derived the formula in a 2014 article in the Financial Analysts Journal.)
A recent example
To illustrate, consider Vanguard’s Intermediate-Term Treasury Index ETF
VGIT.
With an average duration of around 5 ½ years, the researchers formula suggests that a 10-year holding period (twice 5 ½ years, less one) is enough to have the ETF’s total return closely match its initial yield. And sure enough it was: Ten years ago, at the end of 2013’s third quarter, this ETF’s yield was 0.9%; its 10-year annualized return through the end of this year’s third quarter was 0.8% annualized, according to Morningstar.
This despite interest rates today being markedly higher today than then. A naive bond investor who didn’t appreciate what the researchers found about bond ladders would therefore expect that the VGIT would have produced a large loss over this 10-year period.
Given the researchers’ formula, we can predict with considerable confidence the VGIT’s return over the next decade: What it currently is yielding, or 4.8%. And that prediction will hold regardless of how interest rates behave between now and 2034.
What about long-term bonds? The researchers’ formula suggests you will need to hold them for a lot longer than intermediate-term bonds in order to be assured that their return will match their initial yield. For example, Vanguard’s Long-Term Treasury ETF
VGLT
has a duration of 15½ years, according to Morningstar, which suggests you’d need to hold for 30 years (twice 15½, less one) in order to have this assurance. You may conclude that its modestly higher yield (5.2% vs. 4.8%) is not enough compensation for the considerably longer holding period that’s required.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.
This story originally appeared on Marketwatch
