A Different Kind Of Bond Barbell
Jay Kaeppel | May 21, 2019 02:33PM ET
The “barbell” approach to bond investing typically involves buying a long-term bond fund or ETF and a short-term bond fund or ETF. The idea is that the long-term component provides the upside potential while the short-term component dampens overall volatility and “smooths” the equity curve. This article is not intended to examine the relative pros and cons of this approach. The purpose is to consider an alternative for the years ahead.h3 The Current Situation/h3
Interest rates bottomed out several years ago and rose significantly from mid-2016 into late 2018. Just when everyone (OK, roughly defined as “at least myself”) assumed that “rates were about to establish an uptrend” – rates topped in late 2018 and have fallen off since. Figure 1 displays ticker TYX (the 30-year treasury yield x 10) so you can see for yourself.
Figure 1 Courtesy AIQ TradingExpert
In terms of the bigger picture, rates have showed a historical tendency to move in 30-year waves. If that tendency persists then rates should begin to rise off the lows in recent years in a more meaningful way. See Figure 2.
Figure 2: Courtesy mcoscillator.com
Will this happen? No one can say for sure. Here is what we do know: If rates decline, long-term treasuries will perform well (as long-term bonds react inversely to the trend in yields) and if rates rise then long-term bond holders stand to get hurt.
So here is an alternative idea for consideration – a bond “barbell” that includes:
- Long-term treasuries (example: ticker VUSTX)
- Floating rate bonds (example: ticker FFRAX)
Just as treasuries rise when rates fall and vice versa, floating rate bonds tend to rise when rates rise and to fall when rates fall, i.e., (and please excuse the use of the following technical terms) when one “zigs” the other “zags”. For the record, VUSTX and FFRAX have a monthly correlation of -0.29, meaning they have an inverse correlation.
Get The News You Want
Figure 3 displays the growth of $1,000 invested separately in VUSTX and FFRAX since FFRAX started trading in 2000. As you can see the two funds have “unique” equity curves.
Figure 3: Growth of $1,00 invested in VUSTX and FFRAX separately
Now let’s assume that every year on December 31 we split the money 50/50 between long-term treasuries and floating-rate bonds. This combined equity curve appears in Figure 4.
Figure 4: Growth of $1,000 50/50 VUSTX/FFRAX; rebalanced annually
Since 2000, long-treasuries have made the most money. This is because interest rates declined significantly for most of that period. If interest rise in the future, long-term treasuries will be expected to perform much more poorly. However, floating rate bonds should prosper in such an environment.
Figure 5 displays some relevant facts and figures.
Figure 5: Relevant performance Figures
The key things to note in Figure 5 are:
- The worst 12-month period for VUSTX was -13.5% and the worst 12-month period for FFRAX was -17.1%. However, when the two funds are traded together the worst 12-month period was just -5.0%.
- The maximum drawdown for VUSTX was -16.7% and the maximum drawdown for FFRAX was -18.2%. However, when the two funds are traded together the worst 12-month period was just -8.6%.
The “portfolio” discussed herein is NOT a recommendation, it is merely “food for thought”. If nothing else, combining two sectors of the “bond world” that are very different (one reacts well to falling rates and the other reacts well to rising rates) certainly appears to reduce the overall volatility.
My opinion is that interest rates will rise in the years ahead and that long-term bonds are a dangerous place to be. While my default belief is that investors should avoid long-term bonds during a rising rate environment, the test conducted here suggests that there might be ways for holders of long-term bonds to mitigate some of their interest rate risk without selling their long-term bonds.
Like I said, food for thought.
Trading in financial instruments and/or cryptocurrencies involves high risks including the risk of losing some, or all, of your investment amount, and may not be suitable for all investors. Prices of cryptocurrencies are extremely volatile and may be affected by external factors such as financial, regulatory or political events. Trading on margin increases the financial risks.
Before deciding to trade in financial instrument or cryptocurrencies you should be fully informed of the risks and costs associated with trading the financial markets, carefully consider your investment objectives, level of experience, and risk appetite, and seek professional advice where needed.
Fusion Media would like to remind you that the data contained in this website is not necessarily real-time nor accurate. The data and prices on the website are not necessarily provided by any market or exchange, but may be provided by market makers, and so prices may not be accurate and may differ from the actual price at any given market, meaning prices are indicative and not appropriate for trading purposes. Fusion Media and any provider of the data contained in this website will not accept liability for any loss or damage as a result of your trading, or your reliance on the information contained within this website.
It is prohibited to use, store, reproduce, display, modify, transmit or distribute the data contained in this website without the explicit prior written permission of Fusion Media and/or the data provider. All intellectual property rights are reserved by the providers and/or the exchange providing the data contained in this website.
Fusion Media may be compensated by the advertisers that appear on the website, based on your interaction with the advertisements or advertisers.