Phantom Returns

Bond market participants–investors and portfolio managers–are rightly pleased with the returns they have recorded in 2019. YTD returns such as 17% and 9% on 30- and 10-year Treasuries, 12% from investment grade and high yield corporates and 7% from municipals are impressive and gratifying. Those returns, however, do not automatically produce more money in the bank to investors. A sizeable portion could disappear in the months ahead–become phantom returns.

For example, of the 17% total return from the 30-year Treasury, only 2.5% is interest income that is actual cash to the investor. The remainder is from price appreciation. Converting that portion of return to real money requires selling the bonds. For the 10-year Treasury, 7% of the 9% return is price appreciation. Price appreciation accounts for approximately one-half of the YTD returns from municipals and high yield corporates, but 9% of the 12% return from investment grade corporates. Those are the returns that could be eroded if bond prices were to decline.

On the surface, one could make the same argument about equity returns in 2019. Those prices have also increased significantly since January 1. History suggests, however, that the long-run trajectory for equity prices is upward. That is not true for bond prices. As an example, over the past five years, virtually all the total return from the bond sectors mentioned above has been interest income. And, from these historically low yield levels, it would, in my view, be unrealistic to expect the 2019 price gains to persist indefinitely.

If, as now appears likely, the Fed is finished lowering the funds rate, the 2019 bond rally probably peaked in September-early October. If so, converting the price gains into cash would be advisable. That decision is made somewhat easier by the flat yield curves. Shifting from 10- or 30-year Treasuries to bills costs only 25 to 50 basis points of interest income.

Owners of individual municipal or corporate bonds should probably keep them. Selling them is much more difficult and costly that selling Treasuries. Investors who own those sectors in long-duration mutual funds or ETFs might consider shifting to shorter-duration funds.

For investors in high-yield corporate bond funds, credit risk is a greater concern than interest rate risk. If the consensus forecast of continued moderate economic growth in 2020 proves correct, default rates would be expected to remain relatively low. In that event, high yield returns would be expected to be close to average coupon income even if Treasury yields rise.

Selling one’s winners is never easy. A strong case can be made for not doing so in the equity market. With bonds, however, a significant portion of the “winnings” would disappear if market yields were to move only moderately higher in the months ahead. Then, much of the returns that look so impressive now would have been phantom returns.

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