Low Yield ≠ Low Return

by Pat Luby

Low yields do not have to mean low return. (Of course, sometimes Low Yield could equal Low Return, but there’s no math symbol for “does not always equal.”)

Buy and hold bond investors generally know what their “upside” is–the Yield to Maturity. (With the caveat that YTM makes some assumptions that may end up over-or-understating the actual yield earned through the maturity date. I’ll save that discussion for another time, but contact me if you have a question about that.)

Active investors seek to combine the coupon income with capital gains. Consequently, total return indices calculate the combination of interest earned with the gain or loss in market value based on the changes in rates for the period. Total return can be negative–if the amount of principal lost is greater than the amount of interest income earned. Muni bond investors especially should be mindful that capital gains are taxable.

For January 2016, Barclays reports the following total returns (these are not annualized):

  • U.S. Aggregate 1.38%
  • Muni Bond 1.19%

Why should you care? Because there are so many voices trying to encourage investors to time interest rates, they can’t be faulted for thinking that they should avoid bonds when rates are low. However, most often, the best course is more nuanced than the black and white counsel of buy/don’t buy bonds.

It always depends on the goals of the investor–if the objective is to achieve a particular goal, bonds are generally included first and foremost as a non-correlating asset for the equity allocation. Most investors need equity risk for long-term growth, but the biggest influence on reaching a goal is not necessarily the amount earned–very often it can be the amount of losses avoided. (See Andy Martin’s excellent book, DollorLogic for a very readable discussion on this.) To reduce the risk of losses, inlcude a variety of non-correlating assets in the portfolio, so that if equities go down, the non-correlating assets should go up, and vice versa (ideally).

So the next time someone suggests that you avoid bonds because “rates are low,” remember that low rates don’t have to mean low return, and of course–as we’ve seen recently–low rates CAN go lower. (If you want to read more, I have written before about How to Time Interest Rates.)

 

Keep in mind that it is not possible to invest directly in an index. There are ETFs that seek to follow many of the fixed income indices  but their actual performance could vary from that of the index due to a variety of factors.
The opinions expressed and the information contained herein are based on sources believed to be reliable, but accuracy or appropriateness is not guaranteed. Past performance is interesting but is not a guarantee of future results. The author does not provide investment, tax, legal or accounting advice–this is NOT investment advice. Investors should consult with their own advisor and fully understand their own situation when considering changes to their strategy, tactics or individual investments. Investments in bonds are subject to gains/losses based on the level of interest rates, market conditions and credit quality of the issuer. Additional information available upon request.
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