Forecasting Bond Returns and Evaluating Bond Funds

Can we predict the performance of bond funds? This question needs to be separated into two questions: Can we predict the bond market? Can we predict the alpha, or return above (or below) the bond market’s return, of bond managers?1

The bond market is a poor bet going forward. Some managers, however, will earn returns above and below the market return, and it’s valuable to know whether one can select winning managers in the fixed-income asset class.

While past performance is not a guarantee of future alpha, it sure is a hint – the skills needed to generate alpha in a given market are likely to be as valuable in one period as in another. This principle is the basis of selecting active managers. How can we adapt it to bond funds, given the larger market forces at work?

My use of the terms “alpha” and “beta,” which were originally applied to equities, deserves some explanation in the context of the bond market. The returns on any portfolio, in any asset class, can be separated into a beta component – the part due to exposure to market movements – and alpha, the part due to individual manager decisions. In the bond market, the beta component is the return due to the general trend of interest rate. The alpha part is the remainder (positive or negative) of the fund’s return — that is, the part not explained by overall interest-rate movements. Alpha-beta separation is the key to analyzing past performance and predicting future performance in bond funds, just as it is in equities and other asset categories.

Forecasting the bond market is a mystery within a riddle within an enigma, as Winston Churchill described Russia. Stocks are real assets and pay off in proportion to the production and profitability of companies, which can be studied with fundamental analysis. Government bonds, however, pay off in currency, which, in a fiat-money system, is worth what the sovereign issuer wants it to be worth.

This recursive function is difficult to analyze. A government is constrained in its behavior by the need to maintain good enough credit (in real terms) that it can continue to issue bonds into the far future at a reasonable interest cost. Yet if that were a serious restraint, the bond market would not have experienced the massive fluctuations that we are about to review. Bond investors have to be good judges of the tension between the issuer’s need to maintain good credit and its desire to pay bondholders in cheapened currency.

Forecasting manager alpha is another matter. I believe that manager skill exists, yet alphas tend to be low while active risk (the variability of alpha) is very high. This fact makes manager alphas hard to forecast. In this essay, I identify the general types of manager decisions that determine fund performance relative to the market benchmark. The companion to this essay, forthcoming later in 2013, discusses alpha forecasting in greater detail. But first, let’s look at the long-term forces that have driven the overall direction of interest rates and the bond market in the past – and those that are likely to govern rate movements in the future.

Up and down the bond mountain

Many of today’s market participants don’t know much about the history of bonds and interest rates. They know that interest rates were higher in the recent past. They may vaguely remember that interest rates were once very high, and a few older investors may even know that before interest rates were very high, they were low. To remedy this sketchy knowledge, let’s take a detailed look at the history of bonds and interest rates.

Figure 1 shows the “bond mountain,” the tremendous increase in yields between the mid-1960s and the 1981 peak, followed by the equally large decrease from 1981 to 2012. Since 2012, yields have been rising.

Figure 1

Long-term U.S. Treasury bond yields from 1871 to 2013

Long-term U.S. Treasury bond yields from 1871 to 2013

Since bond prices (and, consequently, returns) move the opposite direction from interest rates, the climb up the bond mountain represented a massive bear market. Much of U.S. bondholders’ and savers’ wealth was destroyed, at least in real (inflation-adjusted) terms. The bond bull market that began in 1981 provided very robust returns to a new generation of investors.

I believe, as do many bond market participants, that the bull market is over. Yields will continue to rise, and bond funds will do poorly. Funds that have long durations will underperform those with shorter durations.

1. The alpha in the capital asset pricing model or market model is not just the difference between the portfolio’s return and the market’s return; it is also adjusted for the beta (market-related risk) of the portfolio.