Investing in Bonds #2: The 2 Primary Drivers of Bond Market Returns
14:03 Share

Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte, and today I'm sharing part two of our four-part series on investing in bonds. Specifically, I'm going to dive into the two ways you can generate higher expected returns in the bond market. And as always, the information I'm sharing is based on decades of academic research and not a crystal ball.

So if you've been blindly buying bonds and still not exactly sure what you own and how they're contributing to your portfolio, today's episode is for you. For all the links and resources mentioned, head over to youstaywealthy.com forward slash 86.

Similar to stocks, bonds also have known sources or drivers of higher expected returns. As a reminder, with stocks, there are four drivers of higher expected returns, which we covered last month in episode number 83. And those four drivers were market, company size, relative price, and profitability.

And although the bond market is known to be more complex, there are really only two main drivers to increase expected returns. And technically there's a third, but we'll save that for another episode. So the two main drivers of bond returns are term and credit.

And thankfully, they're both pretty easy and straightforward to understand. In fact, today's entire episode is going to be pretty easy and straightforward. I'm going to be laying the foundation for some more technical concepts, which we'll get into in part three and four of this series later this month. So let's start with term or what's also referred to as the term premium.

The word term simply refers to the maturity date of the bond. Similar to a bank CD, which I think all of us are familiar with, you might buy a bond that matures in one year, five years, or maybe 10 years or something in between. And just like a bank CD, the longer the maturity date, the higher the interest rate you would expect to receive.

In other words, if we're looking at two identical bonds, one that matures in 10 years and one that matures in five years, you should expect a higher return, aka a premium for the 10 year bond. Now, if you're paying close attention, you might have noticed that I said, if we're looking at two identical bonds, and that statement is really important because there are thousands of bonds out there that mature in 10 years, but they don't all have the same expected return.

And that's where the second driver of return comes into play, which is credit or the credit premium. This second driver simply refers to the credit quality of the bond you're buying, which is very similar to your personal credit score being an indicator of your ability to pay back a loan.

If we're looking at two 10-year bonds, the bond with a lower credit rating will have a higher expected return than a bond with a higher credit rating. That's because the bond with a lower credit rating is more likely to default on payments that are owed back to you. Again, very similar to your personal credit score. If you have two friends who need a $10,000 loan, let's say, and one of them has a 500 credit score and the other has an

800, you would probably command a higher interest rate on that loan from your friend who has a 500 credit score because you're a little nervous that he or she may not be able to pay you back based on their credit history.

So remember, when you buy a bond, you're loaning money to that company. And not only do you want some interest for loaning your money, but you want your original loan back too. So by loaning your money to a company with a lower credit rating, you're taking more risk. And as is the case with all investments, the more risk you take, the higher of a return you should expect.

So to recap, the term premium says that if you're evaluating two bonds with similar credit ratings, the longer bond will give you a higher expected return. And the credit premium says that if you're evaluating two bonds with similar maturities,

the lower rated bond should give you a higher expected return. Now, if we put these two drivers together, if you're wanting to create the highest expected rate of return possible in the bond market, you would look for long maturity bonds with very low credit ratings, also known as junk or high yield bonds.

And if you're wanting the absolute safest bond investment and you don't care about maximizing returns, you would look for the shortest maturity bonds with the highest credit rating. And this would essentially lead you to a one month treasury bill, which is pretty much cash under the mattress. Or you might want something in between an investment grade bond, let's say with an intermediate term maturity. And

And in the fund world, this might lead you to something like the Vanguard Total Bond Market Index Fund, where the average maturity sits around eight and a half years and all the bonds are investment grade or higher.

And now you might be wondering, investment grade, what the heck does that mean? What are other grades or credit ratings bonds can have? So unlike maturities, where we all understand the difference between one year and five years, bond credit ratings or grades, they sit on a very confusing letter-based scale.

And to make matters even more complicated, there are three different rating agencies and they all have their own like kind of similar but still unique letter based rating system. And those three agencies you might have heard of before that Standard & Poor's, Moody's and Fitch.

So I like to keep things simple around here, as you know. So let's just keep it simple and say the rating scale essentially goes from AAA, which is the highest rating you can receive, down to the letter D. D is the lowest rating given to a company that's in default. And

And within the A's, there are triple A's, double A's and single A's where the single A's are lower rated than the triple A's. And this translates and you can say the same for the B's, the C's and the D's where a rating of B is lower than triple B.

And I think this is really, really important because a bond fund that you're evaluating may not be a good one.

might label itself as investment grade. And this might lead you to believe it's a safe investment. But if you look under the hood, you might find that all or most of the bonds are at the very bottom of that investment grade scale. Maybe they're all rated triple B. So while technically, yes, it's an investment grade bond fund,

that bond fund owns the riskiest of those investment grade bonds in that asset class. So I'm not saying you should run for your life or anything, but it's important to understand the risk you're taking before investing your hard-earned money. And just relying on a word like investment grade doesn't really give you all the information, which is why it's important to understand the different levels of ratings so that you can target the correct risk return profile that you need to achieve your financial goals.

And that's exactly where I want to round out this episode by putting some real numbers to all of this and sharing exactly how these drivers of returns, term and credit have played out in real life.

To preface, the historical numbers that I'm about to share with you are taken from the Barclays US credit indexes. While you can buy funds that attempt to track an index via an index fund, you can't invest in indexes directly. So it's just important to note. So if we go back to 1983, the Barclays high yield bond index, aka junk bonds with a double B rating, they've had an annual rate of return of 9.3%.

On the opposite end, the intermediate US treasury bonds, the highest credit rating you can find, right? AAA have had an average annual rate of return of 6%. Now, before we go any further, I just want to remind everyone not to compare these returns to the stock market, another asset class, or even a diversified portfolio. We're looking at bonds right now in a vacuum, which is really important to recognize because

Also, remember that bonds and interest rates have an inverse relationship. In other words, when interest rates go down, bond prices go up. And you might remember that interest rates were sky high in the 80s and they've been dropping ever since. So while 6% or even 9% return on your bonds might sound attractive, realize that those types of returns are unlikely to show up over the next 10 plus years.

But that's really all besides the point. What I'm wanting to illustrate here is how the credit premium has shown up in real life. Low-rated risky bonds have had an average rate of return of 9% and highly rated US treasury bonds have had a 6% rate of return. By taking more risk, loaning your money to lower rated companies, you earned a premium return.

However, it's important to understand what that risk is, especially if you're a retirement investor who plans on using your savings to live off of in the very near future, because these lower rated bonds can start to behave like stocks during catastrophic times. And that's the last thing that you want to happen when leveraging your portfolio to fund retirement.

The most recent example of this was for the first quarter of this year, from January 1st to March 31st, the S&P 500, the US stock market index, was down about 20%. And the Barclays high yield bond index wasn't too far behind with a negative return of 10%.

However, our trusted AAA rated US treasury bonds of similar maturity were up just over 5% during that same time period. So stocks are down, high yield bonds are down, and trusted AAA rated US treasury bonds are up about 5.25%.

One thing to note here is the high yield bond index that I'm using is not the worst of the worst. These are double B rated bonds. There are junkier, way worse bonds out there that would have, of course, returned much lower than that. Also, even investment grade bonds, remember those are the triple Bs, those were down 6% during the first quarter of this year. So investment grade bonds, those triple B rated bonds were down over 6% during that same time period. And

And this story has played out many, many times in history. During catastrophic time periods, lower rated bonds start behaving a lot like stocks. And I think this is especially important to keep in mind right now with all the headlines that I'm seeing around record low interest rates and the future bond return expectations. The talking heads and the big banks are suggesting that investors might need to take more risk with their bonds in order to boost their future returns.

As I hope you've learned today, more risk will contribute to higher or should contribute to higher future returns over a long period of time. But that risk can create some short-term troubles, especially for those that plan to use their investment portfolio to fund their retirement and create a reliable stream of income.

This doesn't mean you should swap all of your bond funds for AAA rated US treasuries. It just means that you need to understand the exact amount of risk that you're taking to ensure you're properly diversified and targeting the right risk return profile for your needs and goals. Sometimes we hear the word bonds or investment grade, and we immediately translate those words to mean safe, which is just not true.

And remember earlier when I said it's important to look under the hood of your investments? Well, the Vanguard Total Bond Market Index is a good example of this. This index fund has been slowly removing AAA-rated bonds from its portfolio.

In 2011, about 71% of the Vanguard Total Bond Market Index Fund was in AAA-rated U.S. government and government agency securities. So about 71% of the portfolio in 2011 was AAA-rated bonds.

Today, if you look under the hood of this fund, it's down to about 59%. In other words, this plain vanilla index fund has been getting riskier and riskier and riskier for the last nine years without most people even knowing it. Some of you might know there's a comparable fund out there, which looks almost identical to the Vanguard Total Bond Market Index Fund. And that's the iShares Core US Aggregate Bond ETF, the ticker being AGG.

If you look at both these side by side, they have similar returns. They have the exact same expense ratio, very similar assets under management. However, the iShares fund tracks a slightly different index and it has 74% of its assets in AAA rated bonds.

So while they might appear to be the same exact fund, or at least very similar, I think it's a great example of why we need to better understand these two drivers of returns and exactly how to pinpoint the amount of risk that you're taking in your bond portfolio.

For all the links and resources mentioned today, head over to youstaywealthy.com forward slash 86. I hope today's episode was helpful and I look forward to seeing you back here next week for part three of our four-part series on investing in bonds. And next week is going to get extra nerdy, so get ready to have some fun.

This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.