When it comes to fixed income and bond investing, investors tend to focus on one major headlining factor. And that’s a bond’s coupon. That makes plenty of sense. After all, bonds are fixed income assets and pay steady payments to their holders. The twist to that equation remains a bond’s yield. Coupons generally remain steady, but yield will fluctuate based on the bond’s price.
It turns out what yield you purchase your bond matters a ton with regard to your total return.
And right now could be a great time to start buying bonds. Historical data shows that with yields currently where they are, investors have a great opportunity to realize high total returns: yield plus price appreciation. As such, the time to buy bonds remains now.
The Yield & Coupon Relationship
Stocks represent ownership. Bonds are essentially loans. Typically, when issued, a bond will pay a set coupon or interest rate payment to its holders. This is what puts the ‘fixed’ in fixed income. As long as an investor holds the bond till it matures, they’ll get this coupon/interest payment for the life of the bond.
The wrinkle comes if an investor buys the bond on the secondary market and not when initially issued. Just like with dividend stocks, price determines the yield of the bond. That yield can vary dramatically.
This is playing out today. After the Fed’s inflation fight, rates have risen to the highest levels in about two decades. This has a dramatic effect on bond pricing. Already existing bonds tend to see their prices fall. As the Fed raised rates, the broader Bloomberg Aggregate Bond Index sank by nearly 14%.
This inverse relationship is due to the fact that newly issued bonds coming to market will have a higher coupon than already in-place bonds. Bonds already on the market fall to reflect the new coupons being issued and subsequently see their yields rise. This is exactly what is going on today.
Starting Yield Matters
It turns out that higher starting yields are great determiners for success. That is, when looking at bond sectors and indexes as a whole. That’s the gist according to several studies on the subject.
The Bloomberg U.S. Aggregate Index is the main asset class benchmark and tracks a variety of investment-grade securities. Starting at its launch in 1976, the index has shown that starting yield and five-year forward returns are nearly identical. According to analysts at the Royal Bank of Canada (RBC), the index’s yield-to-worst (YTW)—which accounts for the callability of bonds—explains more than 90% of the expected future return with an R-squared or 0.91 and a correlation coefficient of 0.96. 1
Plotting the data, RBC is able to produce this chart.
Source: RBC
Data from investment manager PIMCO produces a similar result when using yield-to-maturity. The effect is similar when looking at other segments of the bond market as well. For example, insurer New York Life ran a similar study on short-duration, high-yield bonds and found that, here again, starting yields are a big determinant of success and long-term returns.
The question is: Why should this matter? The answer lies within the cushion that high yields provide.
As we said, a bond’s price is what determines its yield. But it’s the duration that drives the price. Duration is essentially how sensitive a bond’s price is relative to interest rates, both increases and decreases. A variety of factors go into this metric including maturity, yield, coupon, and call features. So, a bond with a duration of 2.5 years would see a 2.5% drop in price on a 1-percentage point increase in interest rates.
A high starting yield essentially acts as a buffer against declines and enhances a bond’s total return. When yields are already high, rate increases would drop the price of the bond. However, investors already holding the bond still get the coupon. Cash in hand provides the return and potentially erases losses or still helps generate a positive return.
Need a real-life example of this? In 2022, the yield on the Bloomberg U.S. Aggregate Bond Index was at 1.70%. The rise in rates helped push down prices enough that this yield couldn’t help overcome losses. However, last year, with starting higher yields, bonds managed to produce a positive total return despite seeing some losses on the year as rates increased.
Duration also works in investors’ favor when the Fed does cut. As rates decline, duration works well to boost prices. When the Fed starts cutting rates, investors will look to lock in yield. A higher starting yield can provide more basis for price increases and investor demand.
A Great Starting Position
With data showing that starting yield matters when determining the rate of success and positive returns with regard to bonds, the current environment for portfolios remains good. This is particularly true now that the Fed has started to get serious about cutting rates.
Right now, a variety of bond subsectors are paying some of their highest yields in just over 15 years. Municipal bonds, investment-grade corporates, high yield bonds, etc., all offer compelling high starting yields. That’s great news for anyone looking to see a great total return. If the Fed doesn’t cut rates as expected, there’s a large enough yield cushion for portfolios to stave off any losses and produce a strong positive return. If the Fed does start to cut as expected, demand to lock-in yield will help drive up prices, causing bonds to produce a strong price-driven total return.
The answer is clear: buy bonds. And buy them soon. How to do that is a matter of preference. Depending on the kind of bond—Treasuries, corporates―you may be able to have access to them via your brokerage account. But to get the biggest bang for your buck, going broad makes a ton of sense. Luckily, there are plenty of ETFs and funds that make owning bonds a snap.
Investment-Grade Bond ETFs
These ETFs were selected based on their low-cost exposure to core bonds, Treasuries, investment-grade corporate bonds, and mortgage-backed securities. They are sorted by their YTD total return, which ranges from -0.5% to 0.6%. They have expense ratios between 0.03% and 0.36% and assets under management between $55M and $314B. They are currently yielding between 3.6% and 4.8%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| VCRB | Vanguard Core Bond ETF | $110M | 0.6% | 3.8% | 0.10% | ETF | No |
| HCRB | Hartford Core Bond ETF | $223M | 0.3% | 4.3% | 0.29% | ETF | Yes |
| BND | Vanguard Total Bond Market Index Fund | $314B | 0.2% | 3.6% | 0.03% | ETF | No |
| FIGB | Fidelity Investment Grade Bond ETF | $55.4M | 0.1% | 4.2% | 0.36% | ETF | Yes |
| IUSB | iShares Core Total USD Bond Market ETF | $27.9B | 0% | 3.9% | 0.06% | ETF | No |
| AVIG | Avantis Core Fixed Income ETF | $691M | -0.3% | 4.8% | 0.15% | ETF | Yes |
| AGG | iShares Core U.S. Aggregate Bond ETF | $105B | -0.4% | 3.7% | 0.03% | ETF | No |
| SPAB | SPDR® Portfolio Aggregate Bond ETF | $7.65B | -0.4% | 3.9% | 0.03% | ETF | No |
| GBF | iShares Government/Credit Bond ETF | $330M | -0.5% | 3.8% | 0.20% | ETF | No |
The key lesson is that your starting yield matters. The higher the starting yield, the more cushion you have to absorb bond price losses. Moreover, in falling rate scenarios, this provides more demand once rates start to fall as investors look to lock-in income. With starting rates now at multi-decade highs, the potential for bonds is great. investors shouldn’t let the opportunity slip by.
The Bottom Line
Investors in fixed income securities tend to focus on yield. That’s actually a good thing. It turns out, the higher your starting yield, the better determinant of your success and overall total return. With yields still at decades’ highs, the potential is there for wonderful returns going forward.
1 RBC (June 2024). What can bond yields tell us about future returns?
