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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is president of Bianco Advisors and head of the investment committee for the Bianco Research Total Return Index, which the WisdomTree Bianco Total Return Fund tracks
With the end of the bond market’s historic bull run, is it all over for a particular type of active bond manager — those who pursue returns unconstrained by market benchmarks?
Investor Bill Gross certainly thinks so. He penned one of his must-read monthly outlooks, in which he proclaimed the so-called bond total return strategy, which he pioneered some 40 plus years ago, to be dead. He argued the bond market will continue in a protracted bear market marked by higher interest rates due to higher-than-expected inflation and massive debt issuance to fund continued deficits.
The bond market’s historic 40-year run began with a 10-year Treasury bond yield of 15.84 per cent in September 1981 and ended in August 2020 at 0.51 per cent. Using data from Edward McQuarrie of Santa Clara University, I estimate that during this bull market, bonds produced an eye-popping annualised total return of 9.8 per cent versus an annualised total return of 5.5 per cent from 1793 to 2023.
The pandemic ended these great returns. From 2020 to 2022, the bond market produced losses similar to tech stocks in a correction with returns of negative 26.5 per cent, the worst drawdown since the 1840s.
The bond market is now in a far different place than we have seen in many decades. It now has higher coupons (5.25 per cent on the Bloomberg US Aggregate Index) and shorter durations (where bond prices are less sensitive to interest rate rises). As Jim Grant, the eponymous owner of Grant’s Interest Rate Observer, put it, “it’s nice to have an interest rate to observe again”.
Bond total return investing is not dead. It has just evolved from relying on ever-falling interest rates. Jeremy Siegel, author of Stocks for the Long Run, updated his book last year with Jeremy Schwartz, the global chief investment officer of WisdomTree. The book suggests that the annualised long-run returns for the major asset classes are 8 per cent for stocks, 5 per cent for bonds, 4 per cent for Treasury Bills, and 2 per cent for gold.
Gross is correct in noting that the Vanguard Total Bond Market Index has returned 0.1 per cent in the last five years, including the famine period of 2020 to 2022. With coupons now of 5.25 per cent on US bonds, today’s market has a vastly different risk/return profile than in 2019 when its coupon was under 2 per cent.
Without ever-falling bond yields, the modern total return manager’s job is to protect the income stream from their investments in downturns and augment it in upswings. Quite simply, their job is to do better than so-called coupon clipping — just taking the yield.
The key to this is navigating an uncertain macro environment. The outlook for future inflation, Federal Reserve policy and the fundamental question of what neutral federal funds should be are very much in question, as is the impact of chronic deficits and ever-increasing amounts of bond issuance to fund the government. It is the job of the 2024 fixed income total return manager to assess these and similar risks to position a bond portfolio to first protect the coupon income and second take advantage of the opportunities they present.
Even just looking at current coupon levels, fixed-income total return investing, if done correctly, offers at least two-thirds of the stock market’s 8 per cent potential with far less volatility. But can fixed-income total return investing deliver? Many people believe managers cannot outperform an index — a perception influenced by the stock market. But the bond market is a different animal.
According to the S&P Index Versus Active Report, 80 per cent of equity managers of large capitalisation stocks underperform a benchmark like the S&P 500 over the five-year horizon. However, in the general bond market category, 55 per cent of managers have outperformed their benchmark over the same period. Why? In equities, your biggest weightings are the all-stars. Think of the Magnificent Seven stocks. Equity managers cannot beat an index fund if they are not always all-in on the all-stars, and most are not.
However, in the bond market, the biggest weightings are often the problem children, such as overleveraged companies, low-coupon mortgage securities, and countries that borrow too much debt. Recognising problems and sidestepping them produces big rewards. The fact that most managers have beaten a benchmark index confirms this. The new era just needs a change of style with more focus on coupon protection and risk assessment.
