Without a doubt, bonds have seen amazing performance this year with the total bond market ETF (BND) rising nearly 8%, making 2019 one of the best years on record. Global interest rates have been on the decline and fell deep into negative territory. World central banks seem to want to do everything they can to push bond prices as high as possible in an attempt to “kick the can down the road” on another recession and a nearly inevitable bond bear market.
To put it bluntly, I think bond investors at this level are making a dangerous mistake. The bond market rallied before the equity market fell which indicates the rally was fueled by speculative buying and not economic fundamentals. Yes, the global economy appears to be weakening, but inflation fundamentals are also rising.
I will model the potential impact of rising inflation on BND in this article. To cut to the chase, the impact on the bond market could be disastrous and results in serious long-term declines in the fund’s principal value.
Of course, many will say “inflation is dead” or “interest rates will go lower forever”, recent history would agree, but long-run history would disagree. Low-interest rates and inflation are nothing new, perhaps the problem today is that there are few investors who were in bonds during the 50s-late 70s who can share their story.
To put it simply, for those who want to build secure long-term wealth, the Vanguard Bond fund (BND) is anything but defensive.
The Vanguard Total Bond Market ETF – An Overview
Before we get into the nitty-gritty inflation and interest rate details, let’s asses the fund so we know what we’re working with. The fund invests in U.S. government debt (64%) and U.S. investment-grade debt (36%). That said, 50% of the “investment grade” debt is among BBB bonds that have very high credit downgrade risk today. Only 20% of the fund’s corporate debt is among AAA and AA bonds (7% of the fund in total).
Of course, today it is so hard to accept the ultra-low yields in AAA corporate debt so it makes sense that the fund is concentrated in BBB bonds. Still, in the event of a recession, this exposure may make for poor performance. The average YTM of the fund is merely 2.5% with a weighted average effective maturity of 8 years.
The fund was brought into existence with perfect timing, during the onset of the financial crisis in late 2007. Accordingly, the fund has seen almost nothing but upside and has returned a total of 42% profits to investors with a CAGR of 4.16%.
Over the past twelve months, the fund is up 7.9%, bonds tend to mean revert so it may be a good time for active managers to reduce bond exposure after such profits.
See the total returns of the fund vs. its total AUM:
Take a look at those huge recent inflows and performance. In my opinion, most of the bond market inflows have not been among “smart money” investors and instead have been from retirees and pension funds. Quite frankly, I worry what will become of many of these people’s savings if the trend reverses.
Modeling the Impact of Interest Rates on BND Price
Fortunately, it is a relatively straightforward process to model bond ETFs like BND. To do so, we simply grab the data for 10-year treasury yields, 5-year treasury yields, and corporate bond yields from the Federal Reserve’s database. Since the fund is made up of a mix of these bonds, its yield can be estimated using it.
In this case, I found the best-fit formula for BND’s price to be:
BND Estimated Price = 89/(1+.09*Treasury 10-Year + .25*Treasury 5-year + .12*BBB Yields)^8
Note, if you’re familiar with zero-coupon bond pricing, you may notice that this results in a lower yield than that of BND. This is good because it results in lower volatility and helps us find if BND is overbought or oversold.
This results in a very accurate price that BND mean reverts around:
As you can see, BND tends to fluctuate around the red expected value line that is derived from the three yields on the right axis of the chart. BND is also above the expected line which indicates likely declines.
Importantly, BND has increased exposure to BBB bonds in recent years. Notice how BBB yields skyrocketed in 2008, while treasury yields fell? This may cause increased BBB risk exposure, may create higher downside risk in a recession than what was seen in the last.
Let’s see how BND is likely to react to an increase in interest rates. Investors today all seem to tell themselves that low-interest rate bonds have the lowest risk. Of course, they have the lowest rates because investors believe the bonds have low risk, but the principal risk of rising interest rates among low-rate bonds is immense. Here is a chart of the impact of hypothetical percentage increases to bonds vs. the expected principal value of BND:
I know what you’re thinking “but it is impossible for interest rates to rise to 15%”. Well, we’ve been here before and yes they can. Borrowing from a previous article of mine, take a look at the hypothetical principal value of a 10-year treasury bond (which has similar net rate exposure to BND) from 1950 to 1980:
To put it simply, bonds were a nightmare for thirty years before becoming a haven for a little over 30 years until today. The bond market saw decades of strong performance from the WW1 period to 1950 followed by decades of very poor performance followed by the recent decades-long secular bull market.
Indeed, this is such a long-run trend so it is incredibly easy for investors to say “this time is different” or say “you’ve been proven wrong because rates went lower”. It is an ultra-long run cycle, unless you plan on selling your bonds soon, a bear market will occur.
In my opinion, the recent rally happened for completely irrational reasons. The financial system does not need lower rates and yet rates fell to 5,000 year lows. Frankly, this seems like a classic blow-off of the top that will mark the end of the roughly 36-year bond bull market. Indeed, other economic inflationary signals concur.
Inflation Likely to Surprise to the Upside
Okay, I admit that net inflation is not rising. It’s been falling and has given central banks yet another reason to lower interest rates. That said, inflation is falling primarily because the trade war has depressed agricultural commodities and has pushed down food prices. The fall in crude oil early this year also was a major contributor.
Core inflation and the fundamentals that push inflation higher (currency uncertainty and wage growth) are on the rise. Take a look at the yoy change in gold prices, core PCE, and hourly earnings:
(Source – Federal Reserve)
Wage inflation was mysteriously low up until recently when it has continued to climb despite falling inflation. Remember, inflation is a symptom of more demand than supply. For the past 35 years, supply has arguably been growing faster than demand due to technological improvements (and international outsourcing). Accordingly, wage growth was weak and bonds made for a great investment.
Wage growth tends to be very sticky. Once it starts going it is very hard to stop and it feeds into real inflation because it increases demand and constrains supply (higher wages eventually cause higher unemployment). This is a very long cycle that occurs over the decades and the next paradigm of higher inflation has already begun. It is only time before interest rates rise accordingly.
The Bottom Line – Don’t Hold the Hot Potato
So, bonds are a hot potato and the BND ETF offers investors wide exposure to these potatoes. I admit BND has made for an amazing risk-reward opportunity since its inception, so it is likely emotionally very difficult for investors to decide that the trend will move against them.
This data is not readily available for corporate bonds, but take a look at who’s been the primary buyer of Treasury bonds over the past decade:
(Data Source – U.S Treasury)
Brokers and international investors don’t want the hot potato. It has been investment funds like (BND), (TLT), and (IEF) that have made up the largest buyers in 10-year treasury auctions. In my opinion, dealers and brokers rarely lose so investors are best off following their lead.
Now that BND is back at all-time highs and appears to be falling, I give BND a clear “sell” rating. Unless the stock market crashes, which it may not now that interest rates are so low, I believe bonds (excluding non-TIP/floating rate bonds) have only one direction to go, down. Investors will not accept a negative real yield for so long. For those looking to bet on higher bond prices, long (TBT) (inverse long term treasuries) could be a profitable opportunity.
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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in TLT,IEF,BND over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.