Investing in Bonds

What The Investor Should Expect?

I am an algo trader and I work predominantly with equities and volatility products because these are the assets I am mostly familiar with. A few days ago I came across an article stating that the size of the bond market is quite similar to the one of equities. Afraid of missing opportunities, I have then decided to investigate this asset class: 1- to get more familiar with this domain 2- to understand whether bonds should be a more active part of our NEXT-alpha strategy.

First thing first was to understand the trade-off between CAGR and maximum drawdown. I started by downloading all the bond ETF tickers available on etfdb.com, did some basic calculation and scatter plotted the CAGR vs. the maximum drawdown; see chart below. If you decide to do the analysis yourself, keep in mind you have to use the adjusted close price (i.e. the close price adjusted for the bond yield). The first thing that caught my attention was that investing in bonds can come with a risk! In some cases the drawdown can be higher than what I believe is the max pain threshold of a responsible investor; 10-15%. Whoa!!!

What next? I have then screened the bonds ETFs using two filters:
   1- the historical data should trace back at least 9 years
   2- the maximum drawdown should have been less than 10%.
10% was chosen because, personally this is what I can tolerate for my portfolio and my clients. By applying these two filters, the bond ETFs database shrinks from 493 tickers to 32.

The question now is: what would be the return of a portfolio made solely of bonds?

To do that we need to further screen the remaining 32 tickers to eliminate the ones that are highly correlated to one another. i.e. it is pointless to have in the portfolio the e.g. “iShares 0-5 Year TIPS Bond ETF” and “PIMCO 1-5 Year US TIPS Index ETF” at the same time since essentially they are the same instrument.

We do that and we have 14 tickers left: 97% less than what we started with! If of interest the list is:

1. FlexShares iBoxx 3-Year Target Duration TIPS Index Fund
2. FlexShares iBoxx 5-Year Target Duration TIPS Index Fund
3. iShares 0-5 Year TIPS Bond ETF
4. iShares 3-7 Year Treasury Bond ETF
5. iShares Agency Bond ETF
6. iShares Core 1-5 Year USD Bond ETF
7. iShares Core U.S. Aggregate Bond ETF
8. iShares Intermediate Government/Credit Bond ETF
9. iShares MBS ETF
10. iShares Short Treasury Bond ETF
11. iShares Short-Term National Muni Bond ETF
12. iShares CMBS ETF
13. iShares GNMA Bond ETF
14. Vanguard Total Bond Market ETF

Now that we have the final shortlist, we can combine the timeseries using a Sharpe parity approach and a Risk parity approach. The results are presented in the table below. For reference the last column refers to the benchmark index tracked by the ETF AGG (Core US Aggregate Bond). On a risk adjusted basis (Sharpe ratio and CAGR-Max DD ratio), the two proposed portfolios behave better than the benchmark. From the point of view of absolute return then the proposed portfolios lag behind. Because of my risk aversion nature, personally I would prefer investing in the two proposed solutions. 0.49 as Sharpe ratio in my opinion is not worth.
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For folks used to equities like returns, 1 to 2% CAGR might not seem much but we have to keep in mind that the volatility and maximum drawdown of the portfolio is low. On the other hand on a risk adjusted basis (e.g. Sharpe Ratio), such portfolio shows a value below 1. Not substantially better as compared to equities.

Given the findings, would I invest a larger part of the NEXT-alpha portfolio to bonds?

In short not right now. There are two main reasons behind this answer:

1. The US Federal Reserve has planned to increase the T-bond yields. As result adjusting projected returns for yields and bond market value then this would be a losing trade. In simpler words with raising yields the adjusted close price would trend lower.
2. With inflation being 2 to 3% as historical average (right now 7-8%!!!) with the returns shown in the table above, the real value of the invested capital would decrease over time.

If in the future the 10 year US T-bond yields would settle above 4 to 5% and if the inflation goes back to its historical trend, then it might be time to put some money into the bond market.

What do you think of investing in bonds? How do you approach the bond market?
Type your comments below!