Hedging High Quality Bond Price Losses with Global Yield
May 16, 2018
A fixed coupon rate is common for corporate/government bonds. The Bloomberg Barclays U.S. Aggregate Bond Index (BB US AGG) is an investment grade index with an average weighted coupon of 3.2% as of May 10, 2018. About 72% of the index is composed of high quality AAA–rated bonds, the top credit rating given by rating agencies. Consequently, BB US AGG's historic price has only been slightly impacted by credit–default risk. The index's price is driven by the fluctuating yields of its underlying bonds as compensation to investors for inflation risk or purchasing power risk. Highlights– (Figures 2-3 end on May 11, 2018):
Typically, bond prices (measured as a $1,000 par value) have an inverse relationship with yields. Investors cannot purchase an individual "BB US AGG bond." Hypothetically, let's assume they bought a $1,000 "BB US AGG bond" on May 10, 2018 with a 3.2% coupon rate (red–dotted lines, Figure 1). If new "BB US AGG bonds" are someday issued at 4.2%, the value of an old 3.2% bond declines to $944 to make its market yield equal to 4.2% (shown as a red dot in Figure 1). Figure 1 plots the rising/declining values of "BB US AGG bonds" as yields hypothetically decline/rise (black line).
- Since the Federal Reserve (Fed) began hiking rates on December 15, 2016, cumulative total returns have been 9.3% and -2.0% for global yield and BB US AGG with the 12–month rate of change for inflation (CPI12, Figure 2) rising to near 2.4%.
- Over the past 10 years, BB US AGG has only bested global yield when deflation was evident or when default risk was much higher than inflation risk (May 2008 to Sep 2009 and Aug 2014 to Apr 2016) while global yield has returned 85% and BB US AGG returned a paltry 5.4%.
High quality bond prices began a declining trend in July 2016 as inflation rose from an annualized rate near 0.7% to a current rate near 2.4% and in anticipation of the tighter monetary policy at the Fed. The Fed launched its current cycle of raising its Fed Funds Rate on December 15, 2016.
Figure 2. Inflation, BB US AGG and Global Yield – Since Dec 15, 2016
Chart courtesy of StockCharts.com.
There are many sources of yield. Equities have a history of paying a steady stream of higher dividends, as do other forms of yield, such as real estate investment trusts and energy–related master limited partnerships (MLPs). These sources offer yield about 1% to 5% higher than the BB US AGG Index yield. The Dow Jones Global Yield Index (global yield) hedges losses in high–quality bonds stemming from a rising yield climate driven by higher inflation risk.
Going global with stocks, corporate bonds and sovereign debt loosens an investor's ties to the U.S. economic climate and its markets. Global yield equally weights 150 securities with the highest yields among corporate/sovereign bonds, real estate stocks, equities and MLPs with a fixed allocation of 60% to global stocks and 40% to global bonds.
BB US AGG is capitalization weighted, which requires the index to be heavily weighted to bonds issued by firms with higher–than–average levels of debt within the U.S. investment grade universe. The index is a high–quality index. To remain so, however, it may have to replace existing bonds if their quality slides in the next recession. This credit–default risk might be greater today than at other times in BB US AGG's history.
Figure 3. Inflation, Total Returns for BB US AGG and Global Yield – Last 10 Years
Chart courtesy of StockCharts.com.
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