The vanishing yield cushion

Conventional approaches to fixed income investing rely on bond yields to generate returns. Most of the returns come from accumulating portfolios of bonds to harvest yield.

Simplifying a little, bond yields represent the return from holding bonds to maturity and comprise the bonds’ interest income plus any discount or premium embedded in bond purchase prices.1

The flip side of yield is interest rate duration risk, which is the primary risk inherent in high quality government bond investments. When bond yields drop, bond prices go up, resulting in capital gains for bondholders. The opposite happens when yields rise and the higher the interest rate duration risk, the stronger this effect.

A common way to think about bond yields is to view them as a cushion that protects bondholders from the potential negative effects of duration risk. The yield cushion provides protection from capital losses if yields were to rise.2

The defensive characteristics expected from conventional bond investments also rely heavily on bond yields. In this context, another way to think about the yield cushion is that the stable income provided by bonds, together with the possibility of declining bond yields delivering additional capital gains in adverse scenarios, can cushion a portfolio by helping to offsets losses on equities and other risky assets in such scenarios.

In the context of broader portfolio construction, investors typically expect bond investments to play two roles in their portfolios:

  1. deliver a stable income stream
  2. provide defensive risk diversification

For conventional bond investments, the yield cushion is a key determinant of how well they meet both of these expectations.

When bond yields are high, the yield cushion is large, and bonds do a good job of meeting these expectations. But when bond yields are extremely low, as they are today, bonds deliver less income and become inherently less defensive because the yield cushion is very small.

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As an example, heading into the 2008 financial crisis interest rates and bond yields were a lot higher than they are today, which meant the yield cushion was larger and therefore bonds were able to deliver a decent income buffer, together with large capital gains as interest rates / bond yields declined when equities fell … that was the yield cushion in action.

However, as the table below shows, over the 2018 equity drawdown the protective benefit from conventional bond holdings was much smaller because the starting point of yields was much lower and therefore the yield cushion was small.

Today, that yield cushion is fast approaching zero.

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While this year’s collapse in global bond yields has delivered large windfall capital gains even to simple passive bond holdings (details here), it has come at the cost of a vanishing yield cushion.

As shown in the chart below, global developed market bond yields have now dropped, not only to historically low levels, but have almost hit zero in absolute yield terms.

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This collapse in bond yields has delivered stellar returns for bond investments and coincided with (or perhaps caused) record inflows to bonds that have made the ‘long duration’ trade a very crowded one. Unusually, this has happened over a period in which equities have also performed very well, creating a dynamic where traditional safe-haven investments and riskier assets are all experiencing a highly correlated rally. (details here)

Startlingly, in a growing portion of global bond markets yield cushions haven’t just vanished, they have actually gone negative, causing distorted risk pricing and misallocation of capital. (details here)

All this should be a warning sign that conventional assumptions about portfolio construction and risk diversification may no longer be reliable and it is a bad idea to simply assume that bonds will continue behaving how they have in the past.

The vanishing yield cushion fundamentally changes the risk vs. reward proposition of bonds and challenges conventional assumptions about the diversification value of including conventional bond investments in a broader portfolio.

 

1 For example, if an investor pays $100 to purchase a one-year bond paying a coupon of 5% per annum (i.e. the annual interest payment), at the end of one year the bond will mature and repay $100 of principal, in addition to the $5 interest payment. The investor has earned $5 from holding that bond to maturity, which represents a yield of 5% (i.e. $5 interest divided by the original $100 purchase price).

If the investor had purchased that same bond for a discount to its principal value, say for a price of $95, the yield would be higher because the investor receives the same $5 interest payment plus a capital gain of $5 above the purchase price, when the $100 bond principal is repaid. The investor has therefore earned a total yield of 10.53% (i.e. $5 interest + $5 capital gain divided by the original $95 purchase price).

2 Interest rate duration risk (measured in years) stems from the fact that bond buyers make a payment today in exchange for a series of future interest payments. At the time of purchase, the price of the bond will reflect the present value of that future stream of payments, which are fixed in advance.

However, the next day if the general level of bond yields in the market rises, that fixed stream of interest payments is no longer as valuable, as it is now below current market rates. Therefore, the bond would need to be discounted to attract new buyers, and the bond price drops accordingly.

The longer dated the bond (i.e. longer duration), the more future interest payments need to be discounted and therefore the more pronounced this effect. Hence, longer duration bonds carry more interest rate risk. As an example, a bond with interest rate duration of 5 years would incur a capital loss of c. 5% for every 1% increase in bond yields, while a bond with duration of 10 years would lose c. 10%.