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It is one thing to know a truth; it is quite another to witness that truth firsthand. Most investors know that bond prices move inversely to interest rates and that the longer the duration of the bond, the higher the sensitivity to interest rates. But witnessing that firsthand since last July has been jarring to many nonetheless.
Adding insult to injury for bond investors has been the sharp contrast with U.S. equities, which are 13-19% higher (S&P 500 – Russell 2000) since long bond yields bottomed last July. And as I have chronicled (see here and here), the equity advance in recent months has been among the lowest volatility moves in history.
Over the past year, in fact, the S&P 500 has had an annualized volatility of only 10% (going back to 1928, that’s in the lowest 20% of volatility readings). At 12.4%, the volatility of the 20+ Year Treasury ETF (TLT) has been higher.
On the loss side, long bonds have been exhibiting higher risk as well. Since start of 2013, TLT has had three separate 15+% declines while the S&P 500 has had a maximum drawdown of only 13% (note: closing basis, total return).
Thus far in 2017, while the S&P 500 has had annualized volatility of only 6.5% and has hit all-time highs 15 times, long duration bonds are mired in an 18% drawdown.
So are long bonds riskier than stocks?
Over the past few years, they certainly have behaved as such. But over the longer-term (since inception of TLT in 2002), stocks have been far riskier.
What matters to investors, though, is not just how much risk they are taking, but how much they are being paid for that risk. Last July, bond investors were being paid very little for a higher level of risk (lower the yield, higher the duration, higher the volatility given the same change in rates). Today they are being paid a bit more, which is good news for both volatility and return, for the single best predictor of bond returns are beginning yields.
But don’t get too excited just yet. Long bond yields are still very low in a historical context. They’re just in a better place than last July. Expectations for future returns, then, should remain muted until interest rates really start to rise. The only cure for low bond returns is rising rates.
On the U.S. equity side, we know that investors are paying more today for a given level of earnings than they have been in some time (94th percentile CAPE Ratio). As I wrote recently, that tends to be a leading indicator of higher volatility and risk of loss. So while equity investors have been enjoying a smooth ride of late, they should not get complacent, with the understanding they are likely to be paid less for taking on more risk in the years to come.
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This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.
Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.
You can follow Charlie on twitter here.
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