Today I’m tackling part 3 of our four-part series on investing in bonds.
Specifically, I’m sharing why buying bonds and holding them to maturity might not be the best strategy.
In fact, if interest rates go up and we maintain a normal yield environment, it’s possible that holding bonds to maturity will result in inferior returns.
So if you want to continue learning how bond returns are generated and where there might be opportunities in this asset class, today’s episode is for you.
How to Listen to Today’s Episode
Episode Links & Resources:
- 👉 Get Your One-Time Retirement Plan
- The Yield Curve Last Inverted January 2020 [Bloomberg]
- What an Inverted Yield Curve Means [Reuters]
- Why Bonds Funds Aren’t Necessarily A Losing Proposition In Rising Rate Environments [Kitces]
- Systematic Bond Fund Investing [Dimensional]
Investing in Bonds #3: Rollin’ Down the...Yield Curve
Taylor Schulte: Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte, and today I'm tackling part three of our four-part series on investing in bonds. Specifically, I'm gonna share why buy and bonds and holding them to maturity might not be the best strategy. In fact, if interest rates start to go up from here and we maintain a normal yield environment, it's quite possible that holding bonds to maturity will result in inferior returns.
So if you wanna continue learning how bond returns are generated and where there might be opportunities in this asset class, today's episode is for you. For the links and resources mentioned, head over to youstaywealthy.com/87.
So last week I made a quick comment that bonds and interest rates have this inverse relationship. In other words, if interest rates rise, bond prices fall. And this is a simple fact. It's not a theory or a guess or some sort of prediction on my part. This is just what happens when interest rates rise.
Bond prices fall, and in the early 1980s, interest rates peaked. The Fed funds rate was hovering around 20%, and interest rates have been coming down ever since because interest rates have been steadily falling. Bond prices have been steadily increasing.
And to put that into numbers that we can all understand and have a conversation about since 1980, the Barclays Intermediate US Treasury Bond Index has had an average annual rate of return of about 6.7%. And since these are safe government bonds, you earned that return, that pretty good return, I think we'd all be happy with you earned it by taking about 75% less risk than the stock market.
Now to be fair, the S&P 500, the representation of the US stock market had an average annual rate of return during that same time period of almost 12%. So almost double the return of bonds during that time period, which of course makes sense, right?
Higher risk, higher returns, I think we all know this by now today, with interest rates at record lows, it feels like there's nowhere for them to go but up, which has left a lot of bond investors unsure of what to do and how to invest their bond portfolio to maximize their returns.
Remember, if interest rates steadily increase, bond prices will steadily decrease, which means you probably won't be seeing those 7% annual returns on your bonds. Even worse, in some situations, you might see negative returns on your bonds in some years. And one solution to combat this is to buy individual bonds and hold them to maturity, assuming that you're buying high-quality bonds and the bond issuer doesn't default.
By doing this, you know that you're gonna get your money back when the bond matures, plus some interest along the way. And sure if interest rates rise during that time period, you're gonna see some paper losses on your statement in the short term.
But again, you know that if you just hold that bond of maturity and clip your coupon along the way, you're gonna get your principle back at the end. Plus interest also as discussed in a prior episode, some basic math will tell you with certainty your exact rate of return on that individual bond that you're purchasing or bonds, assuming that they don't default, which you know, to a lot of people, I think brings some comfort, especially for retirement investors who are leaning on their bond portfolio to provide some income.
And while all this can be a prudent approach, buying and holding a bond to maturity in a normal yield curve environment actually gives up price increases each year and reduces your total return.
So I know that's a little complex there. Let's unpack that in plain English and let's just start by describing what a normal yield curve actually is. So in a normal interest rate environment, short-term bonds pay a lower interest rate than long-term bonds. We talked about this in the last episode and referred to this as the term premium.
The longer the maturity, the more risk you're taking, which means you get a higher yield or interest rate in return for that risk. And this is a normal yield curve and a normal environment that we are all used to.
We're not gonna get deep into it today, but believe it or not, the yield curve or portions of it can get flipped on its head where shorter-term bonds actually have a higher interest rate or yield than longer-term bonds. We call this an inverted yield curve, and we actually last saw this happen here in the United States in January of this year.
So with that explanation, let's revisit my previous statement there where I said, holding an individual bond until maturity in a normal yield curve environment actually gives up price increases each year and can reduce your total return. So the first part of that statement should now make sense. You're now an expert on normal yield curves.
Let's tackle the second part about why you're giving up price increases and returns by holding a bond to maturity, which is a bit more technical. Speaking of technical, the technical term for this concept that we're gonna talk about right now is known as roll down return or rolling down the yield curve.
In short, rolling down the yield curve means that you're buying an individual bond and selling it before its maturity date in order to try and boost your total return. And this is a bit of a complex topic, but let's try to illustrate this with a simple example, or at least the simplest example that I could come up with.
Let's say that your time horizon as a bond investor is three years and you're nervous about the current environment and you're a little uncertain about how to invest in bonds. So you decide that you're gonna buy a three-year bond with a 3% yield. The big question here is it possible to earn more than 3%? And in a normal yield curve environment, the answer is yes.
So to keep things simple, let's say three-year bonds are yielding 3%, seven-year bonds are yielding 7% and 10-year bonds are yielding 10%. And again, keeping things simple, let's say that you're buying this bond at par, which is a hundred dollars. Instead of buying that three-year bond with a 3% yield that you're plan, that you were planning on doing, let's say that instead you buy the 10-year bond at 10%, again, we're buying it at par.
So you buy a 10-year bond with a 10% yield for a hundred dollars. Remember, just because you buy a 10-year bond doesn't mean you have to hold it for 10 years. Bonds are liquid and can be sold daily just like a stock. So let's say you buy this 10-year bond with a 10% yield and you hold it for three years.
In other words, after three years, you're, you're now holding a seven-year bond again, you bought a 10-year bond, you held it for three years, and now there's seven years left. So if you sold that bond to me, I would be buying a seven-year bond. Well, as you know, as I just shared in my example, seven-year bonds right now are only yielding 7%. So it wouldn't really make sense for me to be able to pay a hundred dollars, which is what you paid for your seven-year bond that has a 10% yield.
Again, seven-year bonds are only yielding 7%. If I'm able to buy a seven-year bond at par with a 10% yield, that'd be pretty awesome. But that would cause all sorts of problems and inefficiencies in the bond market and the economy to ensure that bonds of similar maturities produce the same total return, the price has to be adjusted.
In other words, I can buy your seven-year bond with a 10% yield, but I'm gonna have to pay a little bit more than you did. And in this example, I might buy this bond from you for $115. So think about what you just accomplished there. You paid a hundred dollars for this 10-year bond, you collected that 10% yield for three years, and then you sold it to me for a 15% profit, which all that is, is quite a bit better than buying that three-year bond at 3%, holding it to maturity and just getting your original a hundred dollars purchase back.
What you just accomplished there, what you just did there was you rolled down the yield curve, you sold your bond before maturity to get a better return. Now this is just one hypothetical bond in a hypothetical three-year time period, just in an effort to kind of keep things simple here.
But imagine if you have hundreds of bonds and you're repeating this process of rolling down the yield curve every single year. This strategy done year over year can produce a significant boost to total returns for a bond investor. And there's a lot of research out there that kind of backs up this whole strategy of rolling down the yield curve.
This isn't just something that I'm making up or a prediction, but as you might be thinking right now doing this, you know, year over year with, you know, a lot more money than just this $100 bond, but hundreds of bonds and you know, again, a lot more money at stake, that would be a lot of work for an individual investor.
Buying and managing individual bonds is enough work on its own, which we talked about a couple of episodes ago. And now you know, Taylor, you're saying that we have to manage the rolling down of the yield curve year after year after year. Yes, that is what I'm saying, which is why this strategy is actually another reason why you might use a bond fund to invest in bonds instead of buying individual bonds and holding them to maturity or trying to manage this.
This rolling down of the yield curve. And when I say bond fund specifically, I'm talking about a bond fund that's managed to produce a stable average maturity. These types of bond funds, which are very different than what I might call like an unconstrained bond fund that's just kind of going rogue and doing whatever they want in the bond market.
These bond funds that are managed to produce a stable average maturity, they trade their bonds in order to keep moving back to that original target maturity, and this allows them to capture additional price return from year to year when we're in this normal yield curve environment. And if the yield curve gets steeper, which means longer-term bonds are really paying a lot more than shorter-term bonds, the total return available by rolling down the yield curve gets higher and higher.
As I've noted several times now, the benefit of this strategy is highly dependent on the slope of the yield curve. Interest rate increases are not always done uniformly, and it all points of the yield curve, which was assumed in my example today. Also, in my example, I'm using a simple hypothetical with US treasury bonds. If we throw corporate bonds into the mix, things get a little bit different.
Corporate bonds have different yields and different yield curves, and it makes the management of all this much more complicated. Lastly, it's important to highlight the cost of pursuing a strategy like this. You know, we talked about in a couple episodes ago, kind of one of the cons of buying individual bonds.
Buying and selling bonds as you well know, is not free. There are trading costs or bid ask spreads, and there are these kind of sometimes hidden dealer markups that can drag down the returns and benefits of rolling down the yield curve because you're not just buying one bond and holding it, you're probably buying a lot more than just one, and you're buying and selling them on a regular basis.
All of this is yet another reason why someone might consider using a bond fund, where these large funds that manage billions of dollars, they have scale and they're able to get better pricing in addition to better pricing.
An investor like you and me, we get the benefit of diversification, which is really, really important when it comes to corporate bonds where there's a chance default and that chance of default has to be factored into this equation. So by using bonds, you get the benefit of better pricing, right?
They get that institutional pricing, they're able to buy at scale, and then you also get that diversification. There are of course, a lot of nuances involved here, which makes it a lot of fun to talk about and share, but it's also really important to make sure that you do your homework and due diligence before taking any action.
Again, I'll link to some of the research in the show notes that kind of backs all this up so you can dig in and learn more. And I would not be doing my job as the host of this podcast if I didn't remind you to talk to your trusted advisors, your financial advisor, your CPA, your attorney, whoever's in your life, talk to them before making these types of investment decisions.
For all the links and resources today, head over to youstaywealthy.com/87 and I will see you back here next week for our final episode of this four part series.
Episode Disclaimer: 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.