Author Topic: How do bond funds generate 5%+ returns when interest rates are sub 3%?  (Read 2141 times)

retireatbirth

  • Bristles
  • ***
  • Posts: 260
I'm looking at Fidelity's Total US Bond Index Fund. The returns over the last decade are actually not bad given the low interest rates and what you hear about bonds. Certainly suits my risk appetite that is now moderating from 100/0 to 90/10 as my investable assets have crossed the quarter million mark.

What goes into these bond returns? Is it simply the effect of higher yielding corporate bonds or is there something else that goes into the returns beyond the actual quoted rates?

   2007   2008   2009   2010   2011   2012   2013   2014   2015   2016   2017
 This Fund   5.40%   3.76%   6.45%   6.29%   7.70%   4.17%   -2.24%   5.93%   0.59%   2.49%   3.11%

https://fundresearch.fidelity.com/mutual-funds/performance-and-risk/316146372

sokoloff

  • Handlebar Stache
  • *****
  • Posts: 1192
Re: How do bond funds generate 5%+ returns when interest rates are sub 3%?
« Reply #1 on: October 28, 2017, 08:00:43 AM »
The "Composition" tab on that same URL you linked shows you what the fund invests in. You can then look up the yield on those instruments that make up the bulk of the allocation. In this specific case, there's a lot of mortgage backed instruments in the fund, which are higher yielding than US Treasuries.

It's also worth noting that, over the last 10 years, that fund has returned 4% (not the 5+% in your subject line)

MrSpendy

  • Stubble
  • **
  • Posts: 133
Re: How do bond funds generate 5%+ returns when interest rates are sub 3%?
« Reply #2 on: October 28, 2017, 08:04:39 AM »
10 years ago the bond index (the index of bonds your fund tracks) had a yield to maturity of 4.5%. this fund has returned 4% over the subsequent 10 years. It underperformed its yield to maturity because rates fell and coupons/maturities were re-invested at lower rates. this was a bigger factor than the benefits from appreciation that come with declining rates. to see the yield to maturity and yield to worst of the bond index over time, use the interactive chart on the right side of the below page.

(note, this is the S&P aggregate index, which is not the main bond index, but it looks very similar to the main index (the barclay's US aggregate bond index which used to be called the lehman aggregate index). there may be subtle differences, but broadly you get the point)
https://us.spindices.com/indices/fixed-income/sp-us-aggregate-bond-index

See this article
https://www.wsj.com/articles/how-to-predict-the-next-decades-bond-returns-1393871478

Quote
ut if you are going to hold bonds for a longer period, the current yield gives you a decent indication of what you might earn over time, says John C. Bogle, founder and former chairman of Vanguard Group. Since 1926, he notes, the entry yield on the 10-year Treasury explains 92% of the annualized return an investor would have earned over the subsequent decade had he or she held the bond to maturity and reinvested the coupon payments at prevailing rates.

Similarly, the entry yield on the Barclays U.S. Aggregate Bond index (of investment-grade U.S. bonds) explains 90% of its 10-year returns for the years 1976 to 2012, says Tony Crescenzi, a portfolio manager and strategist at Pacific Investment Management Co.

By contrast, one figure that doesn't predict bond returns—and which can lead investors astray—is the past return of a bond index or bond fund.  "It is today's coupon, rather than the past return, that determines the future," says Mr. Bogle. A bond might have returned an average of 5% in the past, "but 5% doesn't matter when the initial yield is 3%. It is 3% that will call the tune."

Today the index yields 2.5% ish, so that's probably the most reasonable expectation of returns on a time horizon that approximates the index's maturity (7-10 years)
« Last Edit: October 28, 2017, 08:25:21 AM by mrspendy »

retireatbirth

  • Bristles
  • ***
  • Posts: 260
Re: How do bond funds generate 5%+ returns when interest rates are sub 3%?
« Reply #3 on: October 28, 2017, 08:35:55 AM »
10 years ago the bond index (the index of bonds your fund tracks) had a yield to maturity of 4.5%. this fund has returned 4% over the subsequent 10 years. It underperformed its yield to maturity because rates fell and coupons/maturities were re-invested at lower rates. this was a bigger factor than the benefits from appreciation that come with declining rates. to see the yield to maturity and yield to worst of the bond index over time, use the interactive chart on the right side of the below page.

(note, this is the S&P aggregate index, which is not the main bond index, but it looks very similar to the main index (the barclay's US aggregate bond index which used to be called the lehman aggregate index). there may be subtle differences, but broadly you get the point)
https://us.spindices.com/indices/fixed-income/sp-us-aggregate-bond-index

See this article
https://www.wsj.com/articles/how-to-predict-the-next-decades-bond-returns-1393871478

Quote
ut if you are going to hold bonds for a longer period, the current yield gives you a decent indication of what you might earn over time, says John C. Bogle, founder and former chairman of Vanguard Group. Since 1926, he notes, the entry yield on the 10-year Treasury explains 92% of the annualized return an investor would have earned over the subsequent decade had he or she held the bond to maturity and reinvested the coupon payments at prevailing rates.

Similarly, the entry yield on the Barclays U.S. Aggregate Bond index (of investment-grade U.S. bonds) explains 90% of its 10-year returns for the years 1976 to 2012, says Tony Crescenzi, a portfolio manager and strategist at Pacific Investment Management Co.

By contrast, one figure that doesn't predict bond returns—and which can lead investors astray—is the past return of a bond index or bond fund.  "It is today's coupon, rather than the past return, that determines the future," says Mr. Bogle. A bond might have returned an average of 5% in the past, "but 5% doesn't matter when the initial yield is 3%. It is 3% that will call the tune."

Today the index yields 2.5% ish, so that's probably the most reasonable expectation of returns on a time horizon that approximates the index's maturity (7-10 years)

Oh I see now. Might not get any bonds now.

Radagast

  • Handlebar Stache
  • *****
  • Posts: 1700
  • One Does Not Simply Work Into Mordor
Re: How do bond funds generate 5%+ returns when interest rates are sub 3%?
« Reply #4 on: October 28, 2017, 10:59:15 AM »
The reason is because a declining yield is a result of the bond's price increasing. If yields drop from 5% to 2.5% that is because people have bid up the price of the bond, so you get a capital gain in addition to the original bond yield. When rates rise you get a capital loss in addition to the bond yield. There is no reason bond yields must remain above zero, so mathematically large gains from bonds are still possible at low rates. In general I would make the decision of whether or not to invest in bonds independently of interest rates.

tsukuba

  • 5 O'Clock Shadow
  • *
  • Posts: 35
  • Location: Golden, CO
Re: How do bond funds generate 5%+ returns when interest rates are sub 3%?
« Reply #5 on: October 28, 2017, 12:03:41 PM »
If the rating and performance of the issuer increases, then the value of the bond goes up, just like stocks.

Heckler

  • Handlebar Stache
  • *****
  • Posts: 1354
Re: How do bond funds generate 5%+ returns when interest rates are sub 3%?
« Reply #6 on: October 29, 2017, 12:22:16 AM »
If the rating and performance of the issuer increases, then the value of the bond goes up, just like stocks.

Don't believe  everything you read on forums.

I trust Canadian Couch Potato Bonds Basics series will clear things up for you.  Read 1,2 & 3 (see related posts at bottom)

http://canadiancouchpotato.com/2017/04/13/bond-basics-1-why-bond-prices-fall-when-rates-rise/
« Last Edit: October 29, 2017, 12:24:33 AM by Heckler »

Indexer

  • Handlebar Stache
  • *****
  • Posts: 1455
Re: How do bond funds generate 5%+ returns when interest rates are sub 3%?
« Reply #7 on: October 29, 2017, 09:05:04 PM »
If the rating and performance of the issuer increases, then the value of the bond goes up, just like stocks.

Don't believe  everything you read on forums.

+1.

Few bond price movements are based on performance increases for the issuer. High quality bonds, like the bonds found in the Fidelity Total US bond fund, fluctuate in price based primarily on interest rates. Rates go up, prices go down, and vice versa. Here is the logic. If you have a bond paying 3%, and then interest rates change to where a newly issued similar bond pays 4% then no one wants your 3% bond. If you wanted to sell it you would have to sell it at a discount in order to compete with the new 4% bonds. Example: US Treasuries, they are backed by the full taxing authority of the USA(and in theory, the infinite money printing capabilities of the Federal Reserve). Any questions?

Now there are bonds that will fluctuate primarily based on the performance of the issuer. These are called high yield, or "Junk," bonds. These bonds are issued by companies/countries with the bond equivalent of bad credit. Basically, there is concern that the issuer might not be able to pay the bonds back. In exchange for the extra risk investors demand higher rates. If the issuer's credit gets worse, then the bonds drop in price, and if the issuer's credit gets better the bonds go up in price. Example: Greek government bonds when it wasn't clear if they were going to stay in the Euro... they are still Junk rating, but the rates are down a lot from 2011.

Real life example:  In 2008, US Treasuries(high quality) bonds went UP in value. There was a flight to quality(people wanted to own safe investments), and the Fed started lowering interest rates. In 2008, junk bonds went DOWN in value... a LOT! If I'm selling ABC stock because I think they might go out of business then I'm going to sell their bonds too!
« Last Edit: October 29, 2017, 09:21:46 PM by Indexer »