The total return strategy in bonds is far from dead

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The author is president of Bianco Advisors and head of the investment committee for the Bianco Research Total Return Index, which the WisdomTree Bianco Total Return Fund tracks

With the end of the historic bond market bull market, is it all over for a certain type of active bond manager – those seeking returns that are unconstrained by market benchmarks?

Investor Bill Gross is convinced of this. He wrote one of his must-read monthly outlooks in which he declared dead the so-called bond total return strategy that he developed over 40 years ago. He argued that the bond market will remain in a prolonged bear market characterized by higher interest rates due to higher-than-expected inflation and massive debt issuance to finance persistent deficits.

The bond market’s historic 40-year run began with a 10-year Treasury yield of 15.84 percent in September 1981 and ended at 0.51 percent in August 2020. Using data from Edward McQuarrie of Santa Clara University, I estimate that bonds produced a stunning 9.8 percent annual total return during this bull market, compared to an annual total return of 5.5 percent from 1793 to 2023.

The pandemic ended these great returns. From 2020 to 2022, the bond market experienced losses similar to those of technology stocks in a correction, with returns of negative 26.5 percent, the worst decline since the 1840s.

The bond market is in a very different situation today than it has been for many decades. It now has higher coupons (5.25 percent on the Bloomberg US Aggregate Index) and shorter durations (with bond prices less sensitive to interest rate increases). As Jim Grant, the eponymous owner of Grant’s Interest Rate Observer, put it: “It’s nice to watch an interest rate again.”

Total return investing in bonds is not dead. It has just evolved from dependence on ever-decreasing interest rates. Jeremy Siegel, author of Stocks in the long term, updated his book last year with Jeremy Schwartz, WisdomTree’s global chief investment officer. The book suggests that annualized long-term returns for major asset classes are 8 percent for stocks, 5 percent for bonds, 4 percent for Treasury bills and 2 percent for gold.

Gross is correct when he notes that the Vanguard Total Bond Market Index has returned 0.1 percent over the past five years, including the 2020 to 2022 famine. With coupons now at 5.25 percent for U.S. bonds, today’s market has a very different risk/return profile than in 2019, when the coupon was below 2 percent.

Without ever-declining bond yields, the modern total return manager’s job is to protect the income stream of his investments during downturns and increase it during upswings. Quite simply, your job is to do better than so-called coupon clipping – simply take the return.

The key is navigating an uncertain macro environment. The outlook for future inflation, Federal Reserve policy, and the fundamental question of what neutral federal funds should be are very much in question, as are the effects of chronic deficits and ever-increasing amounts of bond issuance to finance the government. It is the job of the 2024 Fixed Income Total Return Manager to assess these and similar risks in order to position a bond portfolio to firstly protect coupon income and secondly to take advantage of the associated opportunities.

Even just looking at current coupon levels, total return investing in fixed income, when done correctly, offers at least two-thirds of the stock market’s 8 percent potential with far less volatility. But can total return fixed income investments make a difference? Many people believe that managers cannot outperform an index – a perception influenced by the stock market. But the bond market is a different animal.

According to the S&P Index Versus Active Report, 80 percent of large-cap equity managers underperform a benchmark such as the S&P 500 over a five-year horizon. However, in the general bond market category, 55 percent of managers outperformed their benchmark over the same period. Why? When it comes to stocks, the all-stars are your biggest weighting. Consider Magnificent Seven stocks. Stock managers can’t beat an index fund unless they’re always all-in on the all-stars, and that’s not the case for most.

However, problem children are often the most important in the bond market, such as over-indebted companies, mortgage securities with low coupons and countries that take on too much debt. Recognizing problems and avoiding them brings great benefits. The fact that most managers beat a benchmark index confirms this. The new era simply requires a change in style with a greater focus on coupon protection and risk assessment.