Investing in bonds is a cornerstone strategy for many portfolios, providing a balance between risk and reward that is often appealing to both conservative and seasoned investors.

Bonds, essentially loans made to governments or corporations, promise regular interest payments, known as coupons, and the return of the principal amount at maturity.

The total return on a bond investment can come from two main sources: yield, which includes the coupons, and price appreciation. Understanding these components is crucial for any investor looking to maximize their returns from bonds.

While both yield and price appreciation contribute to the total return on bonds, it is essential to recognize that yield and coupons are the more reliable and significant components.

Many new investors might be tempted to speculate on price movements, especially in anticipation of changing interest rates. However, focusing on yield and coupons generally provides a more stable and predictable return.

This note explores the dynamics of bond returns, the impact of interest rates, and why investors should prioritize yield over price appreciation.

Yield and Coupons - The Core of Bond Returns

Yield is a fundamental concept in bond investing, representing the income generated by an investment in bonds, expressed as an annual percentage. This income primarily comes from coupon payments, which are the interest payments made by the bond issuer to the bondholder. These payments are typically made semi-annually and remain fixed for the life of the bond.

The importance of yield cannot be overstated. Historically, the majority of bond returns have come from coupon payments. For instance, during periods of stable or increasing interest rates, the price of existing bonds may decline, but the yield, including the regular coupon payments, provides a consistent income stream. This income is crucial for investors seeking predictable returns, especially those relying on fixed income for retirement or other long-term goals.

Coupon payments work similarly to the interest payments on a loan. When an investor buys a bond, they effectively lend money to the issuer in exchange for these periodic interest payments. The rate of the coupon is determined at issuance and reflects the prevailing interest rates and the credit quality of the issuer. Higher credit risk typically commands higher coupon rates to attract investors.

Price Appreciation - The Speculative Component

Price appreciation in bonds occurs when the market price of a bond increases above its original purchase price. This can happen due to various factors, including changes in interest rates, improvements in the issuer’s credit quality, or general market demand for bonds. However, unlike yield, price appreciation is not guaranteed and can be highly volatile.

Several factors influence bond prices, with interest rates being the most significant. When interest rates fall, existing bonds with higher coupon rates become more attractive, leading to an increase in their market price. Conversely, when interest rates rise, the prices of existing bonds typically fall. This inverse relationship between interest rates and bond prices can lead to price appreciation during periods of declining rates.

While price appreciation can contribute to bond returns, it is often unpredictable and influenced by external factors beyond an investor's control. Historical examples illustrate that price movements in bonds can be significant, but they are not as reliable as yield. For instance, during the financial crisis of 2008, bond prices fluctuated wildly due to market uncertainty, whereas coupon payments remained stable.

Historical Bond Returns - Sources of Contribution

The total return of a bond investment can be decomposed into two key components:

• The yield return

• The price return 

The yield return, also known as the income return, represents the periodic interest payments (coupons) received by the bondholder over the holding period. This component is determined by the bond's coupon rate and accounts for a significant portion of the total return, especially for bonds with higher coupons and longer maturities.

On the other hand, the price return refers to the capital appreciation or depreciation resulting from changes in the bond's price due to fluctuations in interest rates.

• When interest rates decrease, bond prices generally rise, leading to capital gains or price appreciation.

• Conversely, when interest rates increase, bond prices tend to fall, resulting in capital losses or price depreciation.

The relative contribution of each component can vary significantly based on the prevailing interest rate environment and the specific characteristics of the bond, such as its maturity and credit quality.

Example: The 10-Year US Treasury

We downloaded 10-year US Treasury rates from the FRED database.

We then created a series of annual returns based on 1. the yield prevailing as of the end of the prior year (Yield Return) and 2. the price return of the bond attributed to the change in yields from one year to the next.

We decomposed the total return of this one-year holding period into two components: the yield received, and the price return on the bond.

We examined the 1928-2023 period with a special focus on the last four decades. The results are shown in the table below.

Our high-level conclusions are:

• Over the entire sample (1928-2023) the average annual return to the 10-Year US Treasury was 4.83% composed almost entirely (98.6%) of the contribution from the yield.

• The highest yield over our sample period occurred in 1981 reaching 13.7%. This was the era of Paul Volcker when the Fed instituted an aggressive program to fight inflation. I worked at the Dallas Fed at that time and have great admiration for the stewardship shown by Mr. Volcker. He’s probably the last Fed Chairman to ignore political pressures in the course of setting monetary policy.

• Since the peak in the early 80s, we have seen downward trending interest rates creating favorable pricing conditions for bondholders. The contribution total return coming from yield diminished steadily over subsequent decades.

• The downward trend in rates reversed in 2022 as the Federal Reserve started raising rates to fight inflationary forces created by the COVID-19 policy response.

Many investors today are hyper-focused on when the Fed will cut rates. Bondholders will have an immediate favorable price reaction if the Fed cuts rates.

Opinion: I sense that wishing for lower rates is a mistake for the fixed-income investor. It’s asking for bonds to behave like stocks. Stocks already give you lots of volatility and potential price appreciation.

I would rather wish for interest rates to stay higher for longer as a way to ensure that my fixed-income portfolio has an adequate margin of yield premium over inflation. Your fixed-income portfolio should beat inflation without the gyrations of stocks.

Facts: The chart below depicts yields and price returns since 1980.

Notice the downward trend in yields since the early 80s (blue line). Also, notice the volatility of year-to-year bond price returns (the bars in green).

A couple of high-level comments are in order:

• Even though the return to bonds over the 1928-2023 period came almost exclusively from the yield, price returns were positive in 47% of the years. In contrast, the return from yield was positive every single year.

• Since the Volcker days of the early 80s, the proportion of positive price return years has averaged about 60% which is much higher than that observed over the whole 1928-2023 period.

• In a lower rate environment, bondholders enjoy a tailwind contributing to positive total bond returns. That tailwind turned into a headwind in 2022 as the Fed started raising rates.

• The worst year for bondholders over the entire sample period occurred in 2022 when rates spiked up from 1.52% to 3.88% by the end of the year. As a result, the price of the bonds decreased by 19.26%, an all-time low for fixed-income investors.

• The level of the yield to maturity on bonds determines to a large extent what your return will be. If the yields are low, your forward returns will be low. If the yields are high, your forward returns are likely to be high.

The Role Of Monetary Policy

The relationship between interest rates and bond prices is a cornerstone of fixed income investing. When interest rates fall, newly issued bonds offer lower yields compared to existing bonds with higher coupon rates, making the older bonds more valuable. This results in price appreciation for those holding older, higher-yielding bonds.

Historical case studies highlight this phenomenon. For example, during the 2008 Financial Crisis and following the onset of the COVID-19 pandemic, the Federal Reserve implemented aggressive rate cuts to stimulate the economy.

These actions led to substantial price appreciation for existing bonds. However, this appreciation was a temporary effect driven by monetary policy and market sentiment, not a sustainable source of long-term returns.

It's important to understand that while lower interest rates can boost bond prices in the short term, this price appreciation is inherently unpredictable.

Investors who rely on price gains as a primary strategy risk significant losses if interest rates rise or if market conditions change unexpectedly.

Monetary policy, particularly actions by the Federal Reserve, plays a crucial role in shaping the bond market. The Fed uses tools such as interest rate adjustments and quantitative easing to influence economic activity. Lowering interest rates is intended to stimulate borrowing and spending, which can lead to higher bond prices as previously discussed.

• Betting on Fed rate cuts or other monetary policy actions as a strategy for bond investing can be risky.

• Monetary policy decisions are influenced by a complex set of economic indicators and can be unpredictable. Moreover, the timing and magnitude of such decisions are often uncertain.

• For long-term fixed-income investing, focusing on yield and coupon payments provides a more reliable foundation. 

Yield represents the actual income from the investment, and while bond prices may fluctuate, the regular coupon payments offer stability and predictability.

This approach aligns better with the fundamental goal of bond investing: preserving capital and generating steady income.

The Big Picture:

• Investors experienced a mixed week.

• US Large Cap Equities were the second best-performing asset class behind Emerging Market Equities.

• Surprisingly, US Bonds experienced an up week as interest rates on the long end of the yield curve came down 8 basis points on the 10-Year Treasury.

• The big losers last week were holders of US Small Cap Equities. Fears of an economic slowdown weighed on the asset class.

• Year to date US Large Cap Equities and Commodities are the best performing asset classes. Commodities have faltered as of late due to pricing pressures in the oil market.

• The investment environment remains risk-on. Aggressive asset allocation strategies continue their outperformance.

Economy:

• The US economy continues to be whipsawed by changing growth and inflationary expectations.

• Recent reports hint at a slowing jobs market. People are moving less from job to job and are finding it harder to find a new job. The Labor Department reported that job openings in April had fallen to their lowest level (8.059 million) since February 2022.

• The latest unemployment rate rose to 4%, its highest level since January 2022.

Equities:

• US Large Cap equities were up last week 1.4% while the the Russell 2000, our preferred Small Cap Index, was down 2.1%.

• Growth outperformed value last week as traditional value sectors such as Materials, Energy, and Utilities experienced losses.

• Dividend yield strategies which are typically tilted toward value underperformed last week.

• On the international front, the picture was mixed with the US in the middle of the pack.

• European stocks were modestly higher last week boosted by the first cut in rates in five years by the European Central Bank.

• Mexican equities were the worst-performing market in US dollar terms. The Mexican Peso lost 7% last week as the results of the elections became clear.

Bonds:

• The Federal Reserve meets this coming Wednesday. No action on rates is expected, Coincidentally, consumer price inflation is released the same day.

• Yields dropped last week on the long end of the yield curve benefitting primarily holders of long-maturity bonds.

• Investors should be focused on yield as the primary source of return.

• At the moment with an inverted yield curve, short-maturity bonds and cash look more attractive than long-maturity bonds. I don’t think it’s wise to wait for a rate cut. Short yields are attractive.

• Credit also looks more attractive relative to Treasuries given solid economic growth.

Alternatives:

A Bit About Currencies

• For US-based investors who invest in non-US assets, currency fluctuations can have a significant impact on the returns they realize. When investing in foreign stocks, bonds, or other assets, the returns are first denominated in the local currency. However, for US investors, these returns must be converted back into US dollars to determine the actual gain or loss.

• If the US dollar strengthens relative to the foreign currency, any gains in the foreign asset will be reduced when converted back to dollars. Conversely, if the US dollar weakens, the foreign returns will be enhanced for US investors once converted to dollars.

• US investors must be aware of currency dynamics in addition to the fundamentals of foreign assets they buy.

• Monitoring relative currency values is therefore important.

• In the below heat map, positive returns imply US dollar appreciation relative to the chosen currency.

• The US dollar has been appreciating in the last decade denting returns on international assets. In the last 3 years, for example,the US dollar has appreciated versus a basket of major currencies by almost 4% a year.

• Year to date the US dollar has appreciated by 3,8% with major gains relative to the Yen, Mexican Peso, and the Brazilian Real.

• All of the peso’s depreciation occurred last week after the results of the presidential election became known.

• Up to last week the peso had appreciated versus the US dollar. Still, over the last 3 years, the peso is up over 5% annualized,

• There are many reasons why currencies fluctuate in value. Two reasons for the strong performance of the US dollar are higher interest rates in the US relative to most other countries and superior economic performance.

• At the beginning of the year, expectations were for USD depreciation. Such expectations have not materialized primarily as the Fed has chosen for the moment not to lower rates.

Signal Versus Noise

What’s Coming on Premium Wednesday😀 

• Asset Allocation Performance - Portfolio Implications

Disclaimer: This newsletter is not trading or investment advice but for general informational purposes only. This newsletter represents my personal opinions which I am sharing publicly as my blog. Futures, stocks, and bonds trading of any kind involve a lot of risk. No guarantee of any profit whatsoever is made. You may lose everything you have. We guarantee no profit whatsoever, You assume the entire cost and risk of any trading or investing activities you choose to undertake. You are solely responsible for making your own investment decisions. Owners/authors of this newsletter, its representatives, its principals, its moderators, and its members, are NOT registered as securities broker-dealers or investment advisors either with the U.S. Securities and Exchange Commission, CFTC, or with any other securities/regulatory authority. Consult with a registered investment advisor, broker-dealer, and/or financial advisor. By reading and using this newsletter or any of my publications, you are agreeing to these terms. Any screenshots used here are the courtesy of Global Focus Capital and Retirement With Possibilities. The data, quotes, and information used in this newsletter are from publicly available sources and could be outdated or outright wrong - I do not guarantee the accuracy of this information.