How To Predict Bond ETF Returns

April 17, 2017

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Corey Hoffstein, co-founder and chief investment strategist of Boston-based Newfound Research.

Predicting the whims of financial markets is notoriously difficult. Yet the foundation of any prudent financial plan is some sort of long-term return assumption.

Some look toward long-term historical averages, but we believe that, where possible, we should instead leverage forward-looking estimates.

Where and how to derive these estimates is highly debated. We need look no further than the large divergence in forward-looking capital market assumptions from highly respected institutions to see this. For example, J.P. Morgan expects U.S. large-cap equities to return 7.25% annualized over the next decade; Research Affiliates forecasts closer to 2.5%.

The good news is that, with some basic assumptions, the bond side of the equation is much easier; particularly for bond funds. The rule can be summarized as: “Current yield-to-worst is a good predictor of annualized return over the next two times duration minus one years.”

Deriving The Rule

To derive this rule, we make some simple assumptions.

  • We are investing in a bond fund that seeks to maintain a constant duration by rolling over the portfolio at the end of each year. Most popular funds maintain a maturity target, not a duration target, but unless there are wild swings in interest rates, constant maturity is close enough to constant duration to make the rule apply.
     
  • We estimate the return of our fund over a given one-year period to be the initial portfolio yield plus any price change due to changes in interest rates (so we ignore convexity effects, roll return, etc.)
     
  • We assume bonds are trading at par, so we use “yield” and “yield-to-worst” interchangeably.

Here’s a simple example. Let’s assume we hold a bond portfolio that maintains a constant duration of 5 and has a starting interest rate of 0.25%. We will also assume that, over the next decade, rates rise by 0.25% every year.

 

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