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07/11/2019 11:20 am EST
As the Federal Reserve reversed its stance on interest rate hikes earlier this year, the 10-year Treasury note yield fell from 2.69% to 2.07%, writes Joon Choi.
As the Federal Reserve reversed its stance on interest rate hikes earlier this year, the 10-year Treasury note yield fell from 2.69% to 2.07%, which served as a tailwind for both equities and bonds. The Fed is expected to cut interest rates at the end of this month to combat potential economic weakness derived from the on-going trade war with China.
It seems like lower rates are here to stay. This is not good news for bond investors as potential returns from the asset class becomes limited. In a previous article, I suggested increasing high yield bond positions as a replacement for equity positions. But what about investment grade bonds; should you buy and hold these lower yielding products? Here, we will discuss strategies to apply to investment grade bond holdings.
Investment Grade Product Overview
The Vanguard Total Bond Market Index Fund (VBMFX) is an investment grade bond fund that invests approximately 30% in corporate bonds and 70% in U.S. government bonds (Treasury and agency). The iShares Core U.S. Aggregate Bond ETF is almost identical to VBMFX and can be traded without restrictions. AGG currently yields 2.5% with an average maturity of 7.8 years.
The ishares 7-10-year Treasury note ETF (IEF) yields 1.9% with an 8.5-year average maturity. In addition, the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) has a 3.2% yield and an average maturity of 12.9 years. To summarize the three products above, LQD has the highest yield but with largest interest rate sensitivity (highest average maturity), IEF has the lowest yield but there is no credit risk and AGG has a higher yield than IEF even though it has lower average maturity due to the greater credit risk in AGG.
I gathered the daily data for LQD, IEF and VBMFX from July 26, 2002 since that was the launch date for the ETFs. The performance comparison (see table below) shows that LQD had the highest return with the highest risk, which makes sense since it has the longest maturity and the most credit risk. IEF returned 0.5% more than VBMFX (4.7% vs. 4.2%) but with a much greater risk; -10.4% vs. -5.4% maximum drawdown respectively. This may be the reason why most financial advisors recommend diversified investment grade bond funds like VBMFX and AGG instead of Treasury-only bond products for their clients’ portfolios.
However, the rotational strategy would have achieved a higher return rather than holding LQD (6.1% vs. 5.7%) with a drastically reduce maximum drawdown (-8.1% vs. -21.5%). The strategy is riskier than buying and holding VBMFX but it did add almost 2% to the annual return (see table below).
Interestingly, if the investment rotation was done between LQD and IEF, the return shoots up to 7.5% with slightly higher risk. It appears that IEF performs better than VBMFX during unfavorable periods for LQD.
The potential returns from investment grade bond investments are low by historical standards and do not appear likely to improve anytime soon. It may be more profitable to reach for yields in this type of climate by investing in LQD and seeking safety in Treasuries when our proprietary model signals a switch.
Joon Choi is Senior Portfolio Manager, Research Analyst, Signalert Asset Management LLC. He contributes to Dr. Marvin Appel’s Systems and Forecasts newsletter.
We would be glad to review your income portfolio if you are interested in our portfolio management services to incorporate this and our other bond market strategies.
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