Buying Bond Funds? It’s the Arithmetic, Stupid

Returns are capped from here, helping make the case for stocks

By Daniel Putnam, InvestorPlace Contributor

During his speech at the Democratic convention, former President Clinton used the phrase “It’s arithmetic” to deflect Republican concerns about the debt.

But he just as well could have been talking about bonds.

While most segments of the bond market have delivered outstanding gains in the past year, it will be almost impossible for them to repeat the feat in the year ahead. But don’t take my word for it — all you need to do is check the arithmetic.

The math in question concerns duration of the major non-Treasury exchange-traded funds, as first discussed by Simon Lack in his blog, In Pursuit of Value. At their current yields and durations, these ETFs would have to drop to ridiculously low yields to replicate their returns of the past year. This would suggest that, at best, bond investors will be left to “clip coupon” in the months ahead — or, in other words, to collect only yield with little hope for price appreciation.

But there’s a catch: With yields already providing only a modest advantage over inflation, investors don’t have much of an incentive to accept the return provided by coupon alone.

All else equal, this should provide support for the stock market and mitigate against the possibility of a major selloff — absent any negative surprises, of course.

By looking at the duration of an ETF, as Lack did in his blog, we can determine how far the yield on an ETF needs to fall for the fund to provide a certain return. (See the footnote for details).

Here are the returns of the past year for three funds:

  • iShares iBoxx $ InvesTop Investment Grade Corporate Bond Fund (NYSE:LQD): 14.4%
  • iShares iBoxx $ High Yield Corporate Bond Fund (NYSE:HYG): 18.4%
  • iShares JPMorgan USD Emerging Markets Bond Fund (NYSE:EMB): 20.8%

For these returns to be replicated in the year ahead, the ETFs’ average yields to maturity will have to drop to unheard-of levels:

  • LQD: 1.4%
  • HYG: 2.67%
  • EMB: 1.9%

If this sounds somewhat unbelievable, consider that HYG’s 18.4% one-year return has brought its average yield to maturity from 8.96% to 5.84% in the past year.

Admittedly, this is an extreme example: You won’t find many experts who are looking for the bond market’s spread sectors to keep pace with their outstanding gains of the past 12 months. Still, it shows that yields are now so low that the possibility for future price appreciation is much worse now than it was a year ago.

With this being the case, investors are looking at scenario in which yield — rather than price appreciation — becomes the dominant component of total return for the spread sectors. On this count, the three ETFs mentioned above are no longer offering investors an attractive trade-off of risk and return. Assuming inflation stays at its current annualized level of about 1.9%, LQD is now offering investors a real (inflation-adjusted) yield of 0.98%, HYG’s is currently 3.9%, and EMB’s is just 2.3%.

These aren’t exactly the type of yield figures that will attract a stampede of buyers. Quite the opposite, in fact: They are the kind of yields that are going to send investors searching for higher potential returns in equities — especially when iShares Dow Jones Select Dividend Index Fund (NYSE:DVY) offers an inflation-adjusted yield of 1.67% with greater long-term upside.

If this type of reallocation trade begins to take place, how big of an impact could it have?

For an answer, consider this: From January 2008 through August 2012, investors pulled $439 billion out of equity funds and put $982 billion into bond funds. During this time, the S&P 500 Index registered an annualized return of 5.9%. If fund flows were to reverse to only a limited extent, the effect on the stock market could be substantial.

The Bottom Line

This type of relative-value approach among asset classes isn’t a near-term predictor of market performance — just ask BlackRock (NYSE:BLK) CEO Larry Fink, who recommended a 0% bond allocation back in February. Further, a major selloff in the spread sectors is unlikely as long as the Fed keeps pumping cash into the system.

But for long-term investors who find themselves tilted heavily toward bonds, the arithmetic is no longer working in your favor. As a result, any fourth-quarter weakness in the stock market might prove to be an outstanding opportunity to reallocate toward equities.

* If an ETF yields 4% and has a duration of 5.0, a total return of 10% in the coming year (6 percentage points of price appreciation) would imply that the yield should fall 1.2 percentage points (6 percentage points divided by the duration of 5.0), to 2.8%.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

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