YTM vs returns -- Bond ETF 2 years later

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longinvest
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YTM vs returns -- Bond ETF 2 years later

Post by longinvest » 02 Mar 2016 09:21

I first added bonds (VAB*) to my portfolio in January 2014. At the time, many people were saying that aggregate bond index ETFs should be avoided. For example, here's a Globe Investor article that was published on January 30, 2014:

Bond investors should rethink strategy as interest rates rise
George Young wrote:One of the more vexing questions facing investors in 2014 is what to do with the fixed-income portion of their portfolios. After enjoying decades of stable and consistent returns, the traditional fixed-income landscape no longer offers many attractive opportunities. Despite the strong rally in bonds to start this year, there is real concern that 2014 may produce negative returns, echoing last year’s. For bond investors, it is a case of fool me once, shame on you, but fool me twice – shame on me.
I kept record of VAB's YTM at the time. This allows me to compare the YTM of VAB, on January 31, 2014, to VAB's annualized return over the two-year period spanning until January 31, 2016.

VAB's YTM on January 31, 2014: 2.43%
VAB's 1-year return on January 31, 2015: 11.09%
VAB's 1-year return on January 31, 2016: -0.89%
=> VAB's 2-year return on January 31, 2016: ((1 + 11.09%) X (1 + -0.89%))^(1/2) - 1 = 4.93%

Past returns are not indicative of future returns.

I simply don't understand why many investors continue to believe that they can predict a bond ETF's future return using such a simplistic metric as the average YTM of bonds in the ETF. In the short term, reaction to yield movements across all maturities dominates returns (e.g. 11.09% in 1 year, above). In the long term (2 X duration), the initial YTM of new bonds bought with reinvested principal dominates returns. In between, both factors impact returns.

The thing is that no one can predict future yields. So, no one can predict short-term returns (would need to predict yield movements across all maturities), nor long-term returns (would need to predict the initial YTM of bonds bought in the future), nor anything in between (would need to predict both) for an aggregate bond index ETF.

So, which is best, today: investing in VAB at an average YTM of 1.90% or in a 5-year Oaken GIC at 2.50%? Or, maybe it's time to rebalance into stocks? :wink:

* Vanguard Canada's Canadian Aggregate Bond Index ETF.
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Re: YTM vs returns -- Bond ETF 2 years later

Post by big easy » 21 Oct 2017 10:54

Better late than never....

Image

Sorry for the grainy image but you can find the source here:
http://econompicdata.blogspot.ca/2012/0 ... -math.html

The graph shows that YTM is a reasonable predictor of actual return over longer periods of time corresponding to the duration of the index or bond fund. I have been wondering myself how well YTM would predict returns given a changing yield curve and constant turnover of bonds in a fund or index. Actual returns are generally higher than the return predicted by YTM - I suspect this is due to falling interest rates over the time period.

Anyone have a more recent graph? Judging by the current YTM on ZAG and others, it looks like the 6 year return is going to be a pretty miserly 1-3%.
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Re: YTM vs returns -- Bond ETF 2 years later

Post by longinvest » 21 Oct 2017 14:22

longinvest wrote:
02 Mar 2016 09:21
I simply don't understand why many investors continue to believe that they can predict a bond ETF's future return using such a simplistic metric as the average YTM of bonds in the ETF. In the short term, reaction to yield movements across all maturities dominates returns (e.g. 11.09% in 1 year, above). In the long term (2 X duration), the initial YTM of new bonds bought with reinvested principal dominates returns. In between, both factors impact returns.

The thing is that no one can predict future yields. So, no one can predict short-term returns (would need to predict yield movements across all maturities), nor long-term returns (would need to predict the initial YTM of bonds bought in the future), nor anything in between (would need to predict both) for an aggregate bond index ETF.
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Re: YTM vs returns -- Bond ETF 2 years later

Post by big easy » 21 Oct 2017 16:15

I think the graph speaks for itself. I didn't say it was an exact prediction of future return but there is an obvious correlation there.
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Re: YTM vs returns -- Bond ETF 2 years later

Post by longinvest » 21 Oct 2017 16:21

BigEasy,
big easy wrote:
21 Oct 2017 16:15
I think the graph speaks for itself. I didn't say it was an exact prediction of future return but there is an obvious correlation there.
It would be more accurate to say that there was a possibly spurious correlation, there.

I've provided a counterexample, in the first post. Logic tells us that it's sufficient to prove that YTM is not a good predictor. Getting an 11.1% return out of a 2.4% prediction doesn't qualify as good.

Anyway, even if the prediction was good, what could be done with it?
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Re: YTM vs returns -- Bond ETF 2 years later

Post by AltaRed » 21 Oct 2017 16:40

longinvest wrote:
21 Oct 2017 16:21
I've provided a counterexample, in the first post. Logic tells us that it's sufficient to prove that YTM is not a good predictor. Getting an 11.1% return out of a 2.4% prediction doesn't qualify as good.

Anyway, even if the prediction was good, what could be done with it?
To really make the point though, you'd have to wait for duration circa 2021 (2014) to make a more 'sound' comparison. But of course, it is always a moving target depending on what interest rates are at a given snapshot in time. I'd suggest it best to use a 5-7 year rolling average to compare with YTM on VAB.
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Re: YTM vs returns -- Bond ETF 2 years later

Post by longinvest » 21 Oct 2017 16:47

AltaRed wrote:
21 Oct 2017 16:40
longinvest wrote:
21 Oct 2017 16:21
I've provided a counterexample, in the first post. Logic tells us that it's sufficient to prove that YTM is not a good predictor. Getting an 11.1% return out of a 2.4% prediction doesn't qualify as good.

Anyway, even if the prediction was good, what could be done with it?
To really make the point though, you'd have to wait for duration circa 2021 (2014) to make a more 'sound' comparison. But of course, it is always a moving target depending on what interest rates are at a given snapshot in time. I'd suggest it best to use a 5-7 year rolling average to compare with YTM on VAB.
Altared, I've provided the mathematical background to reason about this. It's obvious that it's future yields that will determine the final cumulative returns of a bond ETF, not a simplistic initial metric.

If you think that there is a flaw in my arguments, please show it. A cherry-picked chart doesn't disprove my arguments in any way.
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Re: YTM vs returns -- Bond ETF 2 years later

Post by longinvest » 21 Oct 2017 17:18

Somehow, GIC ladder investors have an easier time understanding this. They don't even calculate the average YTM of their GIC ladder. They focus on the 5-year GIC rate when they have to reinvest a maturing rung. They know that regardless of shorter-term rates, what will mostly determine the long-term returns of their ladder is the average of the rung reinvestment rates over the entire holding period. These are 5-year rates (higher than the YTM in a steep yield curve environment). This average is obviously unknown in advance. They also know that if 5-year rates go up in the future, future returns will eventually end up higher than if 5-year rates go down.

For some reason, many bond ETF investors get this wrong. Instead of considering the yield on the long end of their bond holding, they focus on its average YTM. Also, they think that higher future yields will deliver lower future returns. We can probably attribute this confusion to the focus of the financial press on market-timing metrics for people trading bond ETFs for short-term gains. GIC ladder investors can't do such short-term trading in and out of a ladder.

Anyway, I shouldn't complain. The more people get this wrong, the more it helps VAB's performance. As long as people will keep concentrating their bond allocation into short-term bonds, the price of short-term bonds will keep high and the yield curve will stay steep giving a nice boost to the return of VAB. As for those keeping away from bonds altogether, it's better this way because it keeps demand lower and consequently yields higher than if they invested part of their money into bonds.
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Re: YTM vs returns -- Bond ETF 2 years later

Post by AltaRed » 21 Oct 2017 17:35

longinvest wrote:
21 Oct 2017 16:47
Altared, I've provided the mathematical background to reason about this. It's obvious that it's future yields that will determine the final cumulative returns of a bond ETF, not a simplistic initial metric.
Well, yes, but the average investor wants to 'know' the trend so they always want a proxy for estimating the future and the question then is... what is the best metric for that? And what might I expect for a return?

FWIW, I don't consider fixed income to be anything other than a dampening effect on my equity portfolio, i.e. reduction in volatility, and ultimately some reasonable confidence on capital value. I do that through a ladder rather than an ETF for the simple psychological reason that I know what my value is at maturity.
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Re: YTM vs returns -- Bond ETF 2 years later

Post by big easy » 21 Oct 2017 18:28

Longinvest,

As proof of your argument you compared the 2 year actual return of VAB to the YTM. As Altared pointed out you should be using a 5-7 year forward return in line with the duration of the fund which is 6 years.
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Re: YTM vs returns -- Bond ETF 2 years later

Post by longinvest » 21 Oct 2017 19:16

BigEasy,
big easy wrote:
21 Oct 2017 18:28
As proof of your argument you compared the 2 year actual return of VAB to the YTM. As Altared pointed out you should be using a 5-7 year forward return in line with the duration of the fund which is 6 years.
I've used 1-year and 2-year returns to show that short-term returns are unrelated to the initial YTM; that they're significantly affected by future yields across the curve.

I also explained that long-term returns are significantly affected by future reinvestment yields. This should be pretty obvious to anybody who understands how the total bond market works. GIC ladder investors intuitively understand this.

It follows that the intermediate-terms returns of a total-market bond ETF will significantly be affected by a combination of both future yields across the curve and future reinvestment yields. The key word, here, is: future.

In recent decades, reinvestment yields have been quite similar to the YTM of a few years ealier, because of declining yields across a steep yield curve. This is because YTM is lower than long-term yields on a steep curve. After a while, when yields go down across the curve, the reinvestment yield on the long end of the curve ends up matching the YTM of a few years earlier. It is thus unsurprising to see spurious correlations between returns and initial YTMs over a carefully chosen horizon (of 5 years) over these recent decades.

The average maturity of the US market is 8 years. As a consequence, the natural horizon over which to compare YTM ("yield to maturity") with returns should have been 8 years. The use of a 5-year period by the author of the chart should raise a serious warning of data mining*.

* Data mining is searching indiscriminately through past returns and metrics for a match.

Finally, over longer periods, it is important to compare total cumulative returns, instead of annualized returns. Comparing annualized returns significantly reduces perceived differences, fooling those who don't understand this.
Last edited by longinvest on 21 Oct 2017 22:57, edited 1 time in total.
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Re: YTM vs returns -- Bond ETF 2 years later

Post by big easy » 21 Oct 2017 22:16

There's a thread over at Bogleheads which suggests SEC Yield (YTM-MER) is a decent predictor of future returns. There's even a post by some guy named Longinvest.

https://www.bogleheads.org/forum/viewto ... 3#p2339965
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Re: YTM vs returns -- Bond ETF 2 years later

Post by longinvest » 21 Oct 2017 22:33

BigEasy,
big easy wrote:
21 Oct 2017 22:16
There's a thread over at Bogleheads which suggests SEC Yield (YTM-MER) is a decent predictor of future returns. There's even a post by some guy named Longinvest.

https://www.bogleheads.org/forum/viewto ... 3#p2339965
It seems to me that this longinvest guy is pretty consistent in saying that YTM isn't a predictor of future returns. Here's a link to one of his posts in that thread:

https://www.bogleheads.org/forum/viewto ... 0#p2353672
longinvest wrote: Grayfox, I did not say that the return will be greater than YTM; all I said is that YTM is not its expected return.

There are two components to the yearly return of the ladder. There's a speculative return; the difference in the marked-to-market value of the ladder due changes in the yield curve. There's a fundamental return; the interest payments which amount to the average of 5-year interest rates of the last 5 years. The sum of both returns is as unpredicable as changes in the yield curve.

So, even with such a simplified model, it is impossible to predict future returns with good precision over a specific time period, unless you make unrealistic assumptions such as fix the yield curve (and thus remove any uncertainty about reinvestment interest rates and future ladder valuations).
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Re: YTM vs returns -- Bond ETF 2 years later

Post by longinvest » 21 Oct 2017 22:46

BigEasy,

Here are links to two posts which detail a very simple yet clear example to help understand that YTM isn't a predictor of future long-term returns:
https://www.bogleheads.org/forum/viewto ... 3#p2306215
https://www.bogleheads.org/forum/viewto ... 7#p2306274

Enjoy!
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Re: YTM vs returns -- Bond ETF 2 years later

Post by longinvest » 21 Oct 2017 23:49

I should have checked earlier; we already had a similar discussion in 2014 where I pointed back to the exact same post:
longinvest wrote:
30 Dec 2014 12:57
Big easy,

You might have an incorrect understanding of what the average YTM and average duration of a bond fund represent. They are gross indicators that can help you differenciate funds, but they do not predict future gains or losses.

Here's a simple example I have written on the Bogleheads forums to better understand what the YTM of a bond fund represents: Re: How can Bond Funds perform better than yield.
BigEasy, good luck with your investments. I'll try not to waste any more of your time in the future.
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Re: YTM vs returns -- Bond ETF 2 years later

Post by longinvest » 22 Oct 2017 00:04

For interested readers: Market timing is difficult, even in the bond world. Here's how the total market (VAB) fared relative to short-term bonds (VSB) since my exchange with BigEasy on December 30, 2014:

Source: Portfolio Visualizer

Legend: VSB (blue), VAB (red)
VSB-vs-VAB-2015-01-to-2017-09.jpg
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Re: YTM vs returns -- Bond ETF 2 years later

Post by big easy » 22 Oct 2017 11:12

Agreed, some bonds in a fund will have matured and reinvested with different YTMs which will necessarily affect the fund return. Assuming a 10 year ladder with 10 bonds and a 4 year duration, after 4 years 4 of the bonds have matured and been reinvested into 10 year bonds at different ytm. But if you look at the number of coupons paid by the original bonds over 4 years (approximately 68) vs the number of coupons paid by 4 new bonds (approximately 12). The effect on return of these new bonds will depend in part on the coupons paid on the new bonds relative to the original bonds but is necessary muted due to their lower numbers (12/80 = 15%).

Yes over very longer periods of time, most or all of the bonds will have matured and reinvested and the fund will have a new YTM which is unlikely to be the same. In the short term, price changes on the bonds can overwhelm returns from coupons. In the middle, the relationship seems to hold reasonably well, perhaps because bond prices move in opposite directions to coupons when interest rates change. Or perhaps because interest rates do not tend to move that quickly.

There are other factors like rolling down the yield curve, expenses, individual bond defaults/downgrades, which will affect return. On the whole, the evidence I have seen suggests that there is a correlation between YTM and future return over the duration. The degree of correlation would seem to depend on the degree to which the yield curve changes over that time period.
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