Yield Curve Example (Source DFA Strategies Book):
Sample Yield Curves as of December 31, 2020 - (Source: DFA Fixed Income Update)
Sources for this podcast:
Episode 46 – Fixed Income Investing
What is “Fixed Income”?
• Stocks and bonds are two of the main investment options available in the capital markets
• They are the primary methods through which public companies access capital from investors.
• From the investors’ point of view, bonds can be considered a loan to a company and stocks can be considered a purchase of ownership in a company.
• Due to the characteristics of each type of security, each will provide a different expected return and each plays a unique role in the portfolio.
• Fixed Income can play the following roles in a portfolio:
o Volatility Dampener:
fixed income has lower volatility compared to equity
investors will use fixed income in the allocation to balance out the volatility of their stock investments.
Many fixed income investments are traded on a regular basis and can be bought and sold easily without a major impact on price.
Many investors will hold these types of investments to meet short-term liquidity needs. (ie. bond funds)
Many bonds pay a set coupon payment, and therefore, some investors will use the coupon payments from bonds to generate income or cashflow to meet their obligations.
Keep in mind, cashflow can be generated from the total return of the portfolio, combining the income from investments with the capital gains from stocks
o Inflation Protection:
While at low yields now, certain types of bonds have kept up with inflation over long periods of time (moreso than cash)
Where Returns in Bonds come from (big credit to Ben Felix at PWL Capital, he did a podcast episode 138 where he explained this, I’m going to try and simplify even further)
Bond returns come from 3 places:
1) Current yield of the bond - meaning it’s interest payments (coupouns) plus the discount you received (or minus the premium you paid) when you purchased the bond.
2) Expected capital appreciation or depreciation of the bond based on the current shape of the yield curve
3) Future changes in interest rates (unknown)
How Yield Curves Work:
In a healthy “yield curve”, shorter term bonds have lower yields than similar quality longer term bonds.
Longer term investors accept more risk for “locking up” their capital for longer term, so they command higher returns for doing so
An upward sloping yield curve reflects that investors see other opportunities for their short term/near term dollars (ie. investing in businesses, stocks, etc.) so they command a premium for “lending” their money out for longer periods. It also reflects the perception of a healthy economy, and expectations that interest rates will rise in the future.
Visualization Exercise (there will be a chart in the show notes)
• Picture a chart with Y axis of yield, and x axis of maturity in number of years
• Across that chart is a line that stretches down and to the left, and extends upward and to the right
• Along that line are “plotted” individual bond yields and maturities of similar credit quality (ie. Canadian government bonds)
• On a healthy curve, shorter term bonds have lower yields, and longer term bonds have higher yields, hence why the curve stretches upward and to the left.
• You want to buy a bond
• 5 year bond is yielding 4%
• 4 year bond is yielding 3%
• You buy the 5 year bond
• You hold it for 1 year, and sell it
• Now your 5 year bond has only 4 years left until it matures
• It is now a 4 year bond
• If its yield has stayed the same (4%), and 4 year bonds are yielding 3%, you now have a very valuable bond
• You can go and command a “premium” price for selling it
• So, you will have a capital gain if you sell it
2 sources of risk in a bond – 2 factors that you can target for higher expected returns in bonds:
• Term Premium – longer term bonds are riskier than shorter term bonds, so investors require a premium for holding them
o Investors who hold longer term bonds are taking:
Interest rate risk – the risk that interest rates rise (yields rise, bond prices fall), and they are “stuck” with a lower yielding bond. To “get out of it” they will need to sell the bond at a discount (loss)
Inflation risk – if inflation is unexpectedly high. Longer term bond holders command higher returns to hold long bonds because they are taking more inflation risk
4) Credit Premium – corporate bonds are riskier than government bonds
a. Credit risk is the risk that the company or entity that you lent money to won’t pay you back
b. Arguably, US Government Bonds or Canadian Government bonds, have very little credit risk. Meaning, the debts of US and Canadian Governments are fairly safe from defaulting.
c. Corporate bonds have more credit risk, more risk of default, so investors command higher returns (yields) for holding them when compared to government bonds of similar lengths/terms
Using our criteria:
• TERM PREMIUM
o Persistent – Yes, it has added:
1-5 year bonds have added 0.33% average annual returns over the 1-3 year government bond index
1-10 year bonds have added 0.73% average annual returns over the 1-3 year government bond index
1-30+ year bonds have added 1.18% average annual returns over 1-3 year government bond index
Reference DFA Strategies Book (1976-2017)
o Pervasive – Yes – term premiums have been pervasive in:
Barclays Global Government Bond Index returned 3.04% average annual greater than US 1 month treasury bills index (September, 2000 – March, 2021) – REFERENCE DFA Returns WEB
o Robust – yes, regardless of the terms you measure, longer term bonds outperform shorter term bonds of similar credit quality in the long run
o Sensible/Intuitive – yes, investors who hold longer term bonds are accepting:
More volatility – (BBGB – 2.84% Annual STDV, vs. 0.96% annual STDV for 1 mth T-BILLS)
o Implementable – yes, many indexes and index funds exist at very low prices that can give you exposure to longer term bonds and capture the term premium (tons of ETF’s that target all different maturities of treasury bonds)
• CREDIT PREMIUM
o Persistent – Yes, Credit Premium has been persistent (1989 – 2017)
AAA – 0.46% annual extra returns for corporates over 1-3 yr. treasuries
AA – 0.66% annual extra returns for corporates over 1-3 yr. treasuries
A – 0.81% annual excess returns for corporates over 1-3 yr. treasuries
BBB – 1.28% annual excess returns for corporates over 1-3 yr. treasuries
o Pervasive – Yes, credit premiums have been pervasive
US short Term
US intermediate term (5-10 years) (1973-2017)
Global Intermediate (5-10 years) (1999 – 2017)
As you go from highest credit quality to lowest credit quality, returns and volatility move higher, almost in lockstep
o Robust – yes, across many different timeframes, credit premium is present
o Sensible/Intuitive – yes, if you have 2 choices:
Long term bond from US Government vs.
Same long-term bond from a group of airlines – you’re going to command a higher return for holding the airline bonds, more default risk
o Implementable – yes, there are many corporate bond indexes from many different providers and fund companies, many of which capture the credit premium (I use DFA)
Final Thoughts – Should You pursue Term and Credit Premiums in Your Portfolio?
• Larry Swedroe, in his books, advocates for some exposure to term premium
• He acknowledges that the term premium (holding bonds of intermediate maturities) does add a diversification benefit that does not correlate closely with the other factors we discussed (value, small cap, profitability, beta)
• In other words adding term premiums doesn’t “move in lock step” with equity factors – this is good – we want our fixed income to be a stabilizer in our portfolios
• However, Larry advocates for no exposure to credit (corporate bonds)
• He indicates that credit exposure is really equity exposure in disguise, and there’s no reason to take on the additional risk associated with holding corporate bonds
• But, Dimensional has demonstrated that if you take a dynamic approach to managing your bond portfolio systematically pursuing term and credit factors, you can capture the returns with similar or less volatility
• In a whitepaper completed in 2016, Dimensional simulated a dynamic fixed income strategy targeting term and credit premiums in a systematic way (the same way they manage their fixed income funds for clients but using publicly available data)
• They proved that if you increase/decrease your exposure to different factors when they become cheaper or more expensive, you can add excess returns to a static index-based strategy, with less volatility (meaning the bond component stayed very stable, with higher returns)
• But wait, isn’t this “active management”?
• After all, I don’t advocate for shifting factor exposure when a factor is relatively “cheap” or relatively “expensive”
• The reason why this works is that the returns of fixed income are much more stable and predictable, at least relative to stocks
• You know what you’re getting for cashflow (coupons), you know the price you paid.
• With stocks, expected returns and current valuations are important, but they take a really long time to bear out, in the short run, they are very difficult to use as market timing tools
• With fixed income, the predictability of near-term returns are much more reliable, so you can use a systematic approach (like Dimensional does) that is quite active to target these factors and be successful
• I am not aware of another firm that approaches fixed income this way
o Low cost
o buying/selling bonds all over the world, 12 yield curves
o currency hedging (another topic)
• Next week
o Implementing a factor portfolio
o Final thoughts – who should/shouldn’t invest in factors
• Questions to firstname.lastname@example.org