Deep Dive
Shownotes Transcript
Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I'm your host, David Stein. Today is episode 523. It's titled, Why It's Easier Than Ever to Invest in the Bond Market.
When I became an institutional investment advisor in the mid-90s, working mostly with university endowments, private foundations, typically when we got a new client, they would often have a balanced account manager. It was a separately managed account, might have been a local or regional bank that managed the assets. And the bond portion of the portfolio might have been
a couple dozen bonds. The focus generally was on income. There wasn't a huge focus on outperforming a benchmark like the Bloomberg Aggregate Bond Index, but we would often, as part of the asset allocation and portfolio construction process, introduce a bond mutual fund that could hold hundreds of bonds and had outperformed
the overall bond market, typically having done better than the local bond manager. Nine times out of 10, the bond mutual fund that they ended up retaining was the PIMCO Total Return Bond Fund. It was managed by Bill Gross, and he was incredibly successful at what he did. Most bond management back in the late 90s, even into the mid-2000s, was actively managed.
The management team was actively selecting bond funds. There wasn't that much allocated to bond index funds and certainly not to ETFs.
The first bond exchange traded fund was introduced by BGI Capital Barclays in the year 2000. It just was not something that was done. We used mutual funds because firms like PIMCO and others, their separately managed account minimums were typically $50 million or more. And so it was prohibitively challenging to get a separately managed account. And they needed that size to
in order to build out a diversified portfolio because bonds were generally illiquid. They traded over the phone with dealers. They didn't trade on an exchange like stocks. Turns out most of the bond market even today is still incredibly illiquid. Only about 1% to 2% of bonds trade at least once a day. Most don't trade at all. And there are tens of thousands online
of these bonds. And that's why the bond market's a little challenging and why it's so fascinating to see how it has evolved over the past couple of decades. PIMCO Total Return Bond Fund, it got very large. In fact, that did cause us some concern. Table from Financial Times showed that in 2014, the PIMCO Total Return Bond Fund had $143 billion. Earlier, it had reached close to $300 billion. And
and assets in the 2005 to 2008 period. The second largest bond fund in 2014 was the Vanguard Total Bond Market Index Fund. And so passive management of bonds and mutual funds did become more popular in the early 2000s. If we look at today, the Vanguard Total Bond Market Index Fund is the largest bond fund in the world with $320 billion.
followed by the Vanguard Total Bond Market II index fund at $300 billion. What we need to recognize, though, is Vanguard ETFs are share classes of their index funds. So of that Vanguard Total Bond Market index fund, about $127 billion of it is the Vanguard Total Bond Market ETF, BND.
The largest active bond fund today is the PIMCO Income Fund with $150 billion. And the second largest bond ETF is the iShares Core U.S. Aggregate Bond ETF. Ticker is AGG. So we have seen the rise of bonds.
bond ETFs. I mentioned the first one came out in the year 2000. Now there are over $2 trillion just in the U.S. invested in bonds via exchange traded funds. The bulk of those assets are passively managed. They're tracking some index, but they're not just necessarily tracking the aggregate bond index. And we'll describe in a few minutes what comprises that index.
There are more niche strategies within the bond space and just different indexes, and some are trying to outperform the aggregate bond index. Generally speaking, it's easier to outperform the aggregate bond index than it is for a stock manager to outperform the S&P 500 index. And there are studies that S&P does, Morningstar does, and it shows that
90% of active managers in the stock space underperform a comparable index or a passive ETF. In the bond space over the past five years, about 60% of active bond managers have outperformed their respective index. If we go out 10 years, it's about 40%. But the success rate is higher. Now, there's a reason for that. James Bianco is a fixed income strategist providing research for decades. He
chairs a committee that works with WisdomTree to create an active index that's trying to outperform the Bloomberg Aggregate Bond Index. And then there's a WisdomTree ETF that tracks the index that's trying to outperform a different index. And that's where it gets a little confusing because many ETFs track indexes, but those indexes might be structured in a way trying to actively adjust the weights. And that's what this WisdomTree index does.
Bianco writing for the Financial Times, that when you're trying to outperform the S&P 500, in order to do so, your biggest weights need to be in the biggest holdings in the index, what he calls all-stars, the Amazons, which already make up a large percentage of the index. And especially over the past 10 years when they've done so well, you have to be even more overweight than
Those names and oftentimes active managers prefer to overweight more mid-cap stocks. And that's been a challenging area relative to the mega cap. But Bianco points out on the bond side, the biggest holdings are the problem child, as he points out, because the biggest names have the most debt outstanding. And so one can make different sector allocations and they can also add value.
Bonds that aren't part of the index that might have a higher yield, such as non-investment grade bonds. And so building in a higher yield into a bond portfolio that's yielding more than the aggregate bond index is a way to outperform. And many active bond managers do that. And that's why there's a higher success rate there. Before we continue, let me pause and share some words from this week's sponsors.
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Now, when we think about what is the bond market, it's big. The global bond market, as represented by the Bloomberg Multiverse Index, $73 trillion in size, 31,000 bonds. On Asset Camp, our stock and bond market research tool, we have a chart for different bond indexes that shows the overall size of bonds.
the bond market, such as the global bond market, the US bond market, and we show the number of holdings and you can see how the bond market has changed. And I draw from that asset camp data, which we get from Bloomberg in this episode. So the global bond market, $73 trillion in assets, 31,000 bonds. There are more bonds today relative to the size of the global economy. Back in 2008,
Total global debt, the government debt, corporate debt, all debt as a percent of GDP was about 43%. Today, it's 70%. There are more bonds outstanding as a percent of GDP or the value of what's produced, almost double than it was back in 2008. Now, the U.S. bond market makes up about half of the global bond market, roughly $30 trillion in assets in U.S.
And the core benchmark is the Bloomberg Aggregate Bond Index, $29.3 trillion. That's up from $11 trillion in 2008. Again, more debt outstanding.
We think about where's a lot of this debt coming from, and this is a critical point in this episode. The bond market as represented by the U.S. aggregate has changed over the past 15 to 20 years. Back in 2008, the aggregate market value was 11 trillion. Now it's over 29 trillion. And the biggest change has been the amount of U.S. treasuries. As the U.S. national debt has increased, the amount of
of treasuries outstanding has increased. It's gone from $2.5 trillion in 2008 to $13 trillion today. So $10 trillion increase. And as a result, U.S. treasuries now make up 45% of the U.S. aggregate bond index.
In 2008, it only made up 23%. And so there's more U.S. Treasury bonds outstanding because the national debt is higher. There's also more corporate bonds outstanding. Investment-grade corporate bonds have added about $5 trillion of new outstanding debt in the last 15 years. And so that now makes up 24% of the bond market, up from 18%.
in 2008. So those components have gotten bigger. What's gotten smaller are mortgage-backed securities. These are bonds backed by home mortgages, and it's fallen from 40% of the bond market in 2008 to 25% today because there's only been about $3 trillion more issued compared to $10 trillion of additional treasury issuance. Part of that's the housing crash. It
of 2008 through 2011 to slow recovery, and the national debt in the U.S. has increased essentially faster than the housing market has grown. And so mortgage-backed bonds now make up only a quarter of the U.S. bond market, where it was 40% in 2008. That's the change in the sector allocation. And so to
It's important because when we think about it, and one of our PLUS members, our premium investment community, asked about this, how has the bond market changed over time? We just think we're buying BND, the Vanguard Total Bond Market ETF, and assuming, well, it's the bond market. Well, what it's tracking has changed. More treasuries, more corporate bonds, less mortgage-backed securities, and the interest rate sensitivity of bonds has increased. Well,
what's known as the duration. As interest rates go up, the value of bonds fall. And if a bond fund or ETF has a longer duration because the index it tracks has a longer duration, that means as rates go up, the losses are larger. And the overall bond market, as measured by the U.S. aggregate, lost 13% in 2022. And it caught a lot of investors by surprise. The rise in interest rates has led to a negative impact
annualized return investing in U.S. bonds over the past five years, negative 0.7% annualized. And one of the things that we've seen with the U.S. bond market, it's become much more interest rate sensitive. Back in 2009, the duration of U.S. aggregate was 3.8 years. What that means is if interest rates rose 1%,
a portfolio that has a duration of 3.8 years, we'll see a price decline of 3.8%. It's the back of the envelope kind of calculation for estimating price changes
with changes in interest rates. So it was 3.8 years. Now it's 6.1 years. So it's a lot longer. Part of it is debt that has longer maturity being issued in the treasury market, but it's also a function of mortgage-backed securities. Their duration or interest rate sensitivity changes fairly dramatically as interest rates change. They experience something called negative convexity, which means interest
As interest rates increase, the duration or interest rate sensitivity of mortgage-backed securities increases and they suffer greater price declines when rates increase. To understand why, we have to think about what is a mortgage-backed security. It is a bond backed by home mortgages. And when interest rates are low, that means mortgage rates are low, which means there's more refinancing activity in the housing market. And as mortgage
Mortgages are refinanced. They get paid off early. So there's prepayments and that works to shorten the average maturity and duration or interest rate sensitivity of the mortgage-backed bond index or components of the aggregate. Then as interest rates have increased, the duration of the mortgage-backed securities has extended out.
And I'm astounding how dramatic it is. And I never realized this until we started pulling in the data from Bloomberg and put a chart out on Asset Camp, and we monitor this every month. So in 2020, during the pandemic, very low interest rates, mortgage rates in 2020, 2021, under 3%. The duration of the U.S. Mortgage-Backed Securities Index by Bloomberg, which again makes up about a quarter of the aggregate, was less than one and a half years. And now...
It's six. So it's added five years, four and a half years of duration, which means it's much more sensitive to changes in interest rates. And that drove the increase in duration for the aggregate. And that's why, again, we just can't be naive bond investors. I'm just going to buy BND. We need to recognize that duration matters.
or interest rate sensitivity of the bond index changes over time, and the sector allocation changes over time. One of the other things that's changed is the coupon. The coupon is the average interest rate paid by bonds to make up an index, so the stated interest rate in the bond indenture or the legal contract.
Going back to 1973, that average coupon rate was 6.4%. But today, it's only 3.5% because of all the debt that was issued when interest rates were low. Now, current interest rates are higher than 3.5% today, which means we had thousands of bonds that as rates went up, the price fell.
When we look at the price of the U.S. aggregate, it's around 92 compared to 100, which is the par value that the bond is issued at. So par value is the value used for calculating the actual interest payment based on the coupon rate. But with prevailing interest rates higher, the price has fallen to 92, which means the yield to maturity is
is now higher because, again, prevailing interest rates are higher. So when we look at the yield to maturity on the U.S. aggregate index, right now it's around 4.6%. Long-term, the average has been 6.2%, but 4.6% is really some of the highest yields we've had since really 2008, 2009. And so we had an extended period of very low interest rates. Now they're higher. We're getting higher yields.
James Grant, who writes the Grant's Interest Rate Observer, an industry newsletter focused on fixed income, recently said it's nice to actually have some interest rates to observe since prevailing interest rates are much higher. And that's why it feels better investing in the bond market now because we get higher yields.
So stepping back then, what has changed in the bond market is we do get higher yields now. The bond duration or interest rate sensitivity is higher than it's been going back 15 years. So more interest rates sensitive, primarily due to mortgage-backed securities. The amount of treasury issuance is higher than ever. So it's becoming a larger percent of the index, whereas mortgage-backed securities are a smaller percent. So that's the makeup of the index. Now, the aggregate doesn't include nonpublications.
non-investment grade bonds. So that's about $1.5 trillion in the U.S., about 2,000 non-investment grade bonds. And oftentimes an active bond manager will add that to their portfolio, or we can do it through ETFs.
Here's the other thing, though, when we talk about why it's easier to invest in bonds. We've already mentioned the sheer number of bond ETFs, outstanding, $2 trillion worth in the U.S., but the prevalence of bond ETFs has made the overall bond market more efficient, more liquid, at least for the holdings that make up the ETFs. So I mentioned James Bianco. He wrote
wrote in a piece, I've been in the bond market for over 35 years. And frankly, I now question the need for a manager to use fixed income securities to construct a fixed income portfolio. A fixed income ETF is faster, cheaper, more transparent, and more liquid. And with hundreds of fixed income ETF offerings of every strip and flavor and seemingly more coming daily, why wouldn't you construct a portfolio using fixed income ETFs?
instead of owning thousands of illiquid, hard-to-value securities. And he points out that the Vanguard total bond market ETF, BND, has over 18,000 securities. And it's easier, certainly for us, to structure a bond portfolio using ETFs. Gregory Peters, he's co-chief investment officer at PGIM Fixed Income, said...
The technology around ETFs, even more than the ETF itself, has transformed fixed income trading. And as a consequence, the liquidity of the bond market has improved pretty significantly. It's even more efficient than it was before the great financial crisis, he pointed out. And what's he talking about the technology around ETFs? ETFs are a security that trades on an exchange. A bond ETF will own underlying bonds.
And the ETF is publishing its net asset value per share on an ongoing basis throughout the market day. So what are the value of the underlying holdings? The prices divided by the shares outstanding. That's the net asset value. Now, an ETF is trading also. So its price can differ from the net asset value. It can trade at a premium value.
or a discount. And there are market makers and authorized participants that are monitoring any discrepancy from the market price of an ETF compared to its net asset value. And it can trade with the ETF sponsor. It can purchase shares of the ETF. It can provide the ETF sponsor a basket of bonds, of underlying bonds, and get ETF shares in exchange. Or
or it can take ETF shares of the ETF and give it to the ETF sponsor and get a reference basket of underlying bonds. And the idea is that trading between the ETF sponsor as well as other market-making activity keeps that net asset value and price in line. And the technology of trading these reference baskets, these creation units has expanded significantly
Incredibly, 15 years ago, there might have only been a few trades of these creation baskets in the fixed income space. And there might have been 40 bonds that were traded as part of that basket. Now the baskets can be 350 to 400 securities. Takes five minutes because it's all done electronically now. And so the technology is much better.
It's that underlying trading of those bonds is leading to better liquidity for the bonds that are part of the ETF. For the bonds that aren't included in ETFs, in some regards, their liquidity is just as bad as it's ever been. But here's the thing, and this is where ETFs really stood out. This was during March 2020 as the COVID lockdowns took hold.
the bond market completely clogged up. Everybody was selling, few were buying. And so it was very difficult to trade the underlying bonds. But what did trade and continue to trade were the ETFs. You could buy and sell the ETFs, but because the underlying bond market had frozen up, the ETFs basically became like closed-end funds because it was difficult for authorized participants to narrow bonds
the discount to the net asset value because there was so little trading in the underlying bonds that the prices were stale. But because you could actually trade the ETFs themselves, they in some ways became indicators of what the true value of the bond market was. And it was a fascinating example and it really opened the eyes of a lot of institutional bond managers to take a closer look at ETFs and start using them to a greater degree because the
the process worked. And once the bond market became less frozen, then any premium to discounts narrowed. But the ability to actually trade a bond ETF when the overall bond market was frozen was huge.
Samara Cohen, who is the chief investment officer, BlackRock's ETFs and index funds said, it was a huge moment for fixed income ETFs. Traders were packing up their Bloomberg to work from home and couldn't trade bonds, but you could trade ETFs. They provided really important price discovery during that volatile period and helped create more resilience for the bond market. It was a huge change.
And because of ETFs and the ongoing trading and the additional liquidity that the cost, transaction cost, the spread between the bid and ask price has fallen between 4% and 15%, depending on the bond sector. So you're seeing more liquidity in the bond market for bonds that are part of ETFs. But keep in mind, there are tens of thousands of bonds and a lot of them still don't trade very frequently. The other thing that...
has brought down the transaction costs for bonds is there's more electronic trading.
49% of U.S. investment-grade corporate bond market is now done electronically versus over the phone through dealers. 35% of non-investment-grade can trade by algorithm. And it's much easier to just trade portfolios of bonds, partly because of ETFs. And that's been a big change. So when we step back and think about why is it easier than ever to invest in bonds, the underlying mechanisms are so much better now. The
liquidity of bonds due to ETFs. That has brought down trading costs. It has brought down management fees. We can invest in the entire bond market for three basis points. And we can choose because there's so many options now. We can choose what level of interest rate sensitivity or duration we want. What credit quality do we want? What sector exposure? We can buy bullet ETFs that have a set maturity.
the sheer ways to go about it, it's incredible. And what we're even finding is active bond managers that have traditionally been in the mutual fund space, they're seeing this change and they're issuing ETFs. DoubleLine just issued a new ETF that tracks asset-backed securities, which are bonds backed by certain type of assets like credit cards and car leases. And we did a plus episode on that for our premium members. The premiums
presence of ETFs and investing in bonds that does increase tax efficiency. And so when I think about investing in bonds, my first thing I do is I consider using an ETF and then decide which one, how I want to be positioned in the bond market. And that's a lot of what we talk about on Money for the Restless Plus. We spend a lot of time talking about bonds and how to be positioned and they have different opportunities. I'm incredibly grateful that the bond market is much easier to participate in than
than it was 20 or 30 years ago. That's a real advantage to us as individual investors because we have more options and lower cost. The institutional fixed income world recognizes that also, and more and more, they're also using ETFs to implement their strategies. That's episode 523. Thanks for listening.
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