How To Predict Bond ETF Returns

April 17, 2017

Implications For Bond ETFs Today

Using this rule, we can look at popular bond ETFs today and derive our expected returns:

  Ticker Yield-to-Worst Duration

Return Through

U.S. Aggregate AGG 2.56% 5.74 Q3 2027
1-3 Year U.S. Treasuries SHY 1.26% 1.93 Q1 2020
5-7 Year U.S. Treasuries IEI 1.80% 4.47 Q1 2024
7-10 Year U.S. Treasuries IEF 2.25% 7.57 Q1 2031
20+ Year U.S. Treasuries TLT 2.89% 17.39 Q1 2051
Investment-Grade Corporates LQD 3.47% 8.27 Q3 2032

Source: iShares. Calculations by Newfound Research.

Using this rule, we can see that the outlook for bonds is not particularly rosy.

We have to point out that, for longer maturity positions, like TLT, our assumptions may not be appropriate: Convexity can play a large role in returns, and it is very unlikely that interest rates move in a predominately linear fashion over the next 34 years. Furthermore, credit spreads will play an important role in the results of LQD, and those effects are not modeled here.

That said, the other estimates may still give us pause for concern: Filling 40% of our portfolio with bonds slated to return an annualized 2.56% for the next decade, before inflation, is not the most attractive proposition.

Rethinking Bonds: Unbundle And Rebuild

We’ve written at length in the past about our philosophy to approaching fixed income today: an approach we call “unbundle and rebuild.” The ideas behind this approach are to identify the purposes for which we are investing in fixed income; identify investment solutions for each of those purposes; and blend those solutions.

We generally highlight four major purposes for which we see investors holding on to fixed income for today: capital preservation, income, diversification and hedging/crisis alpha.

In the case of capital preservation, a high-quality, short-duration bond portfolio may still do the trick. The “two times duration minus one” rule can be used here to help match cash flow needs.

For income, we believe there are two approaches:

 

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