Page 44 - DIY Investor Magazine - Issue 28

CONFUSED BY BOND ETFS? 2 THINGS THAT MATTER WITH RISING RATES (BOND ETFS VS. CASH) Everyone has an idea about how the stock market works, yet even by pros Bond markets are widely misunderstood; by retail Investors, they are often just dismissed as ‘uninteresting’. Yet Bond ETFs can lose 10% or 20%+ in a short timeframe; they can also ‘pop’ during a crisis delivering unexpected returns. Is keeping cash preferable in the current environment? Here are some answers. BONDS ARE GLAMOUR Some Bond ETFs are as volatile as stocks and since the 1980s trading Bonds became sexier than trading equities. In his book, Liar’s Poker, Michael Lewis describes Salomon Brothers’ training program for new hires back then: ‘After the end of the program, the new analysts are placed into various divisions of the firm with the most coveted desk being the mortgage bond desk and the least desirable one being Equities’ - and particularly, trading equities in Dallas, its smallest satellite office, which became training program shorthand for ‘Just bury that lowest form of human scum where it will never be seen again’ WHY BONDS MATTER Bond rates drive all markets, even equities, which is why Wall Street tries to decipher every single nuance in Central Bankers’ speeches. For long term investors, understanding the way they work, in a rising interest rate environment, can help in answering key questions: • How much can I gain/lose by holding Bonds ETFs vs. Cash? • Are Bond ETF losses temporary? If so, when will coupons offset any price losses for my Bond ETF? • Is there any other upside of holding Bond ETFs vs. Cash? Bond analysts usually sound smarter than equity analysts, because bond language is geeky; Bonds are complex, but that’s what drove their success. Because the Pareto Principle (aka the 80% / 20% rule) holds for Bond ETFs as well, grasping just two concepts – Yield and Duration – will help you understand 80% of what matters in Bond ETFs, especially vanilla Government Bonds (Gilts) which you may buy for your long term portfolio . I let the 20%, including all the jargon, aside which helps in explaining Bond ETFs to the Golden Retriever; after all, it’s one of the building blocks of the Golden Retriever Portfolio. Here is an attempt to demystify Bond ETFs, including a Bond ETF Calculator that only takes these two inputs to get intuitive sense of what is the upside/downside of Bond ETFs vs. Cash. THE RETURN YOU GET (YIELD) You don’t need a price when you trade a Bond; because you look at historical Equity ETF and Stock prices you also check them for Bond ETFs. Equity prices indicate how bumpy the road ahead may be, and what returns you may expect. For Bonds, historical prices do not matter; apart from showing you that yields have gone down for decades, which you already knew, charts of Bond prices are quite useless. A Bloomberg Terminal has a YAS Screen (Yield and Spread Analysis) allowing traders to calculate yields; Bond pros do not quote a $ price – they quote a yield. Predicting the future gets even more interesting; while for Equities the future is largely unknown, for Bonds future returns are known – hence ‘fixed income’. Jack Bogle noted, since 1926, the initial yield on the 10-year Treasury explains 92% of the total return an investor would have earned over the subsequent decade – held to maturity, with coupons reinvested at prevailing rates. Short term Bond returns can diverge drastically from expected yield to maturity; for investment banks trading Bonds is a lucrative business. For a long term Bond investor, regardless of fluctuations, holding to maturity locks-in the initial Yield; however how high rates rise, the Bond price is ‘pulled’ to par (initial or close to initial price) as maturity gets closer. DIY Investor Magazine | Apr 2021 44