How To Predict Bond ETF Returns

April 17, 2017

In year one, we collect our 0.25% yield, but lose -1.25% due to increasing rates (-5 x 0.25%). In year two, we now collect 0.5%, but still lose -1.25% due to increasing rates, and so on and so forth. We can plot this profit and loss over time:

One way to think of this profit and loss is in excess of our initial yield: 

Let’s focus, for a moment, only on the returns from extra yield and losses due to rate changes. We can see, over time, how those two effects net out:

We can see that, while losses from rising rates cause a net performance drag in early years, the much higher yields earned at the end of the period are enough to turn returns positive.

If we hold for exactly “two times duration minus one” years—in this case, 9—the cumulative net excess profit and loss averages out to zero, and we end up just earning the starting yield every year.

Thus, starting yield becomes the predictor for return over the next “two times duration minus one” years.

 

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