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.
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.
Implications For Bond ETFs Today
Using this rule, we can look at popular bond ETFs today and derive our expected returns:
|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:
- Embrace a diversified portfolio of higher-income asset classes and strategies (e.g., levered loans, emerging market debt, mortgage REITs, etc.). Recognizing that this excess yield does not come free, we believe an approach that focuses on actively managing risk is critical.
For example, in Newfound’s Multi-Asset Income strategy, we diversify across 16 high-income asset classes and strategies, and use a trend-following overlay to remove exposures deemed to be a risk to capital safety, even introducing short-term U.S. Treasuries if necessary to reduce portfolio volatility.
- For investors looking to use income to satisfy withdrawal and spending needs, a target income approach can satisfy income needs and take investor focus off the principal.
For example, in Newfound’s Target Excess Yield suite, we build portfolios that seek to consistently achieve specific yield targets while minimizing fluctuation in principal. An investor could leverage this portfolio almost as a personalized liability-driven investment approach, covering withdrawal and income needs without having to focus on the principal.
For diversification, we believe investors can look both toward alternative asset classes (e.g., equity long/short, relative value and event-driven strategies) and alternative means of managing risk. Instead of relying on a static fixed-income position to manage downside risk, investors can reduce some of that exposure and introduce an active approach to managing risk.
For hedging/crisis alpha, there are few exposures that “pop” like Treasuries in a flight-to-quality period. That said, there may be opportunities to introduce exposures like managed futures, which have historically performed well during crisis periods.
Having identified solutions for each of our fixed income needs, we can then rebundle the approaches based on a mix that targets our specific goals and outcomes, hopefully avoiding a decade-long purgatory of low bond returns.
At the time of writing, Newfound Research owned positions in all the ETFs mentioned above. The company is a Boston-based quantitative asset management firm focused on rules-based, outcome-oriented investment strategies. Newfound specializes in tactical asset allocation and risk management solutions. The company offers a full suite of tactical ETF managed portfolios covering global equity, U.S. small-cap equity, multi-asset income, fixed-income and liquid alternative asset classes. For more information about Newfound Research, call us at 617-531-9773, visit us at www.thinknewfound.com or email us at [email protected]. For a list of relevant disclosures, click here.