Understanding Fixed-Income Returns

Perhaps the most important concept to understand about bonds is that they are debt. Debt is a loan and borrowers do not pay more than they are contractually obligated to. The implications is that even under ideal conditions, future returns are both known and limited. Below are several reference points that investors can use to predict future returns.

Starting yields have been a fairly good predictor of Treasury returns:


Within credit, starting spreads have been good predictors of future returns:


Spreads are also indicative of future excess returns:


The above charts convey an important message: be aggressive when future returns are high and defensive when future returns are low. Fortunately, fixed-income investors can get a sense of future returns in the present (as a point of comparison, this is very different from equity markets where expensive assets can get more expensive and cheap assets can get cheaper). Invest accordingly.

Liquidity Dynamics in Fixed-Income Markets

We are continuing to examine a few foundational sub-topics before getting into the meat of the active versus passive debate for fixed-income. Last week, we looked at the composition and tax implications of fixed-income returns. Today we will be looking at liquidity in bond markets.

I find that the layperson is familiar with the stock market and understands that equities are traded electronically on centralized exchanges. Bonds are quite different however. Consider a few of the below points:

  • Many bonds are traded over the phone, rather than electronically. There is a big push towards electronic trading and a majority of US Treasuries may trade electronically now, but most corporate, mortgage, and muni issues still trade via phone.
  • There is no centralized exchange (electronic or otherwise), but a network of brokers and dealers who request quotes from one another.
  • Very few bonds trade on a given day. While nearly all stocks trade every day and many times over, very few bonds trade every day. Many US Treasury and Agency bonds trade every day, but a large portion of investment grade corporate bonds do not. A minority of high yield bonds trade on any given day and just a fraction of muni bonds trade on most days. For instance, both my clients and I own many bonds that have not traded in months.

Each of the above points contribute to wide bid-ask spreads. That is, the difference between what buyers are willing to pay and sellers are willing to accept is wide. When bid-ask spreads are tight and liquidity is deep, it does not much matter whether you’re a buyer or a seller because either will get close to the same price. But if bid-ask spreads are wide, then buyers and sellers will get quoted very different prices. Buyers will be quoted higher prices and sellers will be quoted lower prices. This type of market can be either good or bad, depending on the investor.

Investors who are forced to buy or sell are at a disadvantage. If an investor has some discretion over trading, he/she can exploit this illiquidity by selling when people want to buy and buying when they want to sell. The more illiquid the asset class, the more you want to be in control of buying and selling decisions. This dynamic certainly impacts how allocations evaluate manager mandates, fund structure, product wrappers, as well as management style (active vs passive) which we’ll get into more in coming weeks).

Fixed-Income Taxation & Implications for the Active vs Passive Debate

Before diving into an analysis of active versus passive management in fixed-income, it may be helpful to cover a few foundational topics. First up is taxation.

Tax-efficiency is major tailwind for passive management in equities, but not so much in bonds.

First, let’s look at some reasons why equity index funds are tax-efficient:

  • Equity returns are composed of both appreciation and dividends. Under the current US tax code, short-term capital gains are taxed at ordinary income rates and long-term capital gains are taxed at 15-20%. Furthermore, “qualified dividends” also receive favorable tax treatment. Thus, there are a lot of tax benefits to reducing turnover in an equity portfolio.
  • The ETF structure allows for in-kind redemptions (and creations, but that’s beside the point) and many equity index fund managers have been able to minimize or avoid any capital gains exposure since their inception.

Now let’s examine how these factors contrast with fixed-income:

  • The majority of a bond’s return is from interest. Bond prices do fluctuate and investors can capture gains and experience losses, but a bond will only return a fixed-amount over its life. Hence the term fixed-income. Under the current US tax code, interest income is taxed at ordinary income rates. Even if an investor captures some appreciation, he/she will likely need to attribute a portion of the gain as income. Thus, there is not as much of a tax incentive to hold on to bonds for longer than need be, as investors will largely be taxed at ordinary income rates regardless of holding period.
  • The bond universe is much larger than the stock universe, but also less liquid. Thus, bond ETFs utilize in-kind redemptions less than their equity fund counterparts, which means that there is often capital gains exposure.

Obviously the tax laws can change, but passively-managed fixed-income does not currently enjoy the same tax benefits as passively-managed equities. This does not mean that active management is necessarily better in fixed-income (that depends on many other factors which we’ll explore in coming weeks), but the hurdle is not quite as high.