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.)