Bond fund's next frontier

October 3, 2015 09:00 AM

Implications for the future

Perhaps the most vital step in the investment process is establishing appropriate expectations. And while past performance is not indicative of future results, performance history can provide insight as to the range of results going forward. If the future is similar to the past then the investment should perform as expected, and if the future is more favorable than the past then the investment performance should exceed expectations. 

The danger arises when the future is worse than the past. Investment risk can be defined as the difference between “anticipated worst loss” and “realized worst loss,” and setting those expectations based on the past 30 years could prove to be particularly treacherous in this case. 

Why might the future be different? Current rates are so low that to continue on their historic pace of decline would require them crossing into negative territory.  

We can already see this in the one-year yields, which have effectively hit zero. Even if rates decline into negative territory, in order for the future to resemble the past they would have to drop well below -10%. Now ask yourself: What is the duration of the typical bond fund? How might they be affected if interest rates stop falling and their 30-year tailwind vanishes? And what happens if rates increase and that tail wind becomes a headwind?

There are more than 3,000 bond funds from the likes of Blackrock, JP Morgan, Fidelity and Vanguard available for investment. In total, there is approximately $16 trillion held by mutual funds, 22% of which represent allocations to bonds funds.

“Best in bonds,” (below) shows a listing of the bond mutual funds offered by Fidelity, which have a Morningstar rating of 4 or 5. These represented the highest grade Fidelity bond funds available for investment today and total over $94 billion in invested assets.

The table shows the fund ticker along with its current duration and total return during the last five years. For instance, the Fidelity Massachusetts Fund (FDMMX) has returned a total of 25.7% from May of 2010 to May of 2015. Over this same period the yield on 20-year U.S. government bonds has fallen 2.16%. Using the information in the table we can get a rough estimate of how much fund performance has been affected by changes in interest rates. Using a rate drop of 2% and 6.63 as a proxy for the historic duration of FDMMX, we can estimate that from the 2% rate drop alone, the FDMMX should have made at least 13.26%. That is more than half of the total return it actually achieved. 

Furthermore, we can see that the correlation in the value of that fund to 20-year yields is quite strong at negative 0.7783. 

FDMMX is not the only fund that relied heavily upon the declining interest rates to drive performance. In fact, the average five-year total return for these funds is 26.5%, while the current average duration across all the funds is 5.51. That implies that a yield increase as low as 2.4% — which would bring 20-year yields up to just 4.75% — could wipeout half of the gains made in the last five years for the entire group. 

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About the Author

Rob Matthews develops technical trading strategies as Research Director for Covenant Capital Management.

Josh Ireland performs statistical research as head of Covenant’s Analytics Department.