Bonds as an asset class, have done extremely well over the last 35 years or so. In 1981, when the great bond bull market began, the asset class was despised. Soaring inflation had shaken investors’ faith in both equities and bonds as a vehicle for their hard-earned savings. US Treasuries – which offered yields of more than 15% at the time – were described as “certificates of confiscation”.
Then, however, Federal Reserve chief Paul Volcker raised interest rates in the US to double-digit levels. It was painful and resulted in a recession – but it also squeezed inflation out of the system, and marked the dawn of a new era. Bond yields continued to fall throughout the 1990s as globalisation picked up and the likes of China and eastern Europe opened up to the world, driving down production costs and leading to an era of disinflation, which was also fuelled by the rise of the internet. Then we had the financial crisis and the great bogey man became not inflation, but deflation.
It’s only now that the banking system has been largely patched up in both the US and Europe, and that global growth seems to be getting stronger, and that employment in most parts of the developed world is at extremely high levels, that investors seem willing to contemplate the possibility that inflation might just be on its way back. And that even if it isn’t, growth rates probably justify bond yields being a bit higher than they are today.
Of course, as bond yields rise, bond prices fall (like a seesaw – as one side goes up, the other goes down). And it increasingly looks as though summer 2016 marked the absolute bottom for bond yields. So far this year, many of the largest bond ETFs have lost money. The question now is – how high might yields rise, and what does that mean for investors in bonds – and bond ETFs in particular?
Bond ETFs were popular last year
Duration is a key concept in fixed income – put simply, it represents how sensitive a bond or bond fund is to changes in interest rates. A duration of 10 for example, would suggest that for every percentage point rise in interest rates, the value of the fund would drop by 10%. Typically, the longer a bond has to go before it matures, the higher the duration, whereas short-term bond funds are less sensitive to interest rate changes, and thus – assuming the bonds themselves are ‘safe’ sovereign bonds – are relatively less risky (although they’re still not exactly cash substitutes).
Bond ETFs have made it easier for individual investors to access the fixed-income market cheaply. However, there are some key differences between bond and equity ETFs. Bonds are an over-the-counter market (whereas equities are exchange-traded) which means that it is a less liquid, more opaque market. Replication of the underlying indices is also more of a challenge than for an equity ETF, which means you should be very alert to tracking error. There are also regular mutterings about how the lack of liquidity could impact on bond ETFs if there is a genuine panic sell-off in the market – we may just have to wait and see on that one.
These are all issues to be aware of if you are considering investing in any bond ETF. But the other big one, more specific to today’s environment, is the potential reversal for the asset class. My own view is that an inflationary surprise is more likely than not (although that’s a view I’ve had for a while, I’ll warn you) and so if you’re an actively-inclined investor, then I’d consider dialling down your portfolio’s exposure to rising interest rates and a more hostile environment for bonds – in other words, reduce your duration risk. For example, while in 2017, bond ETFs drew in $138bn in new investor cash, compared to $112bn in 2016, a lot of this money went into short duration funds.
Also, if you feel more aggressive, and would like to actively bet on bond prices falling (and yields rising), then there are “inverse” bond ETFs that will do the job. You want to look for ETFs that track indices with longer duration (for example, one popular – if somewhat expensive – option is the US-listed Proshares Short 20+ Treasury). Just bear in mind that these ETFs are rebalanced daily, so you need to keep a close eye on their performance as it will gradually diverge from the underlying index over time (and much more quickly than that if you buy a leveraged inverse ETF).
Of course, this could all be a false alarm. In 2012, it looked for a time as though the bond bull market was over. And if markets become sufficiently rattled by political volatility, we may find that the rush for “safe haven” assets sends investors fleeing back into Treasuries and other developed world sovereign debt. But if the bond bubble really has finally burst, we could be entering an investment environment the likes of which most of us have never encountered. It’s worth preparing for that possibility, by introducing a bit of flexibility to your portfolio, just in case.