BND: Bonds Away

About: Vanguard Total Bond Market ETF (BND)
by: David Pinsen

When trends continue for decades, investors can come upon inflection point unawares. A quote from the inflection point at the start of the secular bond bull market illustrates this.

Some market participants have argued that the 10-year Treasury yield rising above 3% this year may be a similar inflection point.

In the event it is, I present a hedge for BND here. I also discuss an alternate approach for investors with the same risk tolerance but looking for higher returns.

Photo of Tom Wolfe, via Bing

Bonfire Of The Bond Market Trends

Bonfire of the Vanities, the satiric novel by the late Tom Wolfe (pictured above) about bond salesman Sherman McCoy's life unraveling, proved to be prophetic in its social themes. Prophecy about the bond market proved to be tougher. In an early scene (pp. 58-59 in the Picador paperback), Sherman's boss at the fictional bond house Pierce & Pierce, Gene Lopwitz, gives his long view of the US Treasury bond market. After remarking on how rich bond brokers had become, Sherman recounts:

In the Lopwitz analysis, they had Lyndon Johnson to thank. Ever so quietly, the U.S. had started printing money by the billions to finance the war in Vietnam. Before anyone, even Johnson, knew what was happening, a worldwide inflation had begun. Everyone woke up to it when the Arabs suddenly jacked up oil prices in the early 1970s. In no time, markets of all sorts became heaving crap-shoots: gold, silver, copper, currencies, bank certificates, corporate notes - even bonds. For decades the bond business had been the bedridden giant of Wall Street. At firms such as Salomon Brothers, Morgan Stanley, Goldman Sachs, and Pierce & Pierce, twice as much money had always changed hands on the bond market as on the stock market, but prices had only budged by pennies at a time, and mostly they went down. As Lopwitz put it, "The bond market's been going down ever since the Battle of Midway." The Battle of Midway (Sherman had to look it up) was in the Second World War.

Recall that bond prices move inversely with yields, and you can see from the chart of 10-year Treasury yields below (via Observations and Notes) that Lopwitz's quip about the bond market going down since the Battle of Midway (1943) was essentially correct.

Chart via Observations and Notes

Bond yields started taking off in earnest in the 1950s, and that trend continued into the 1980s. What's interesting is that by the time Bonfire of the Vanities was published in 1987, bond yields had already started their long downtrend leading to the current decade (the chart above ends in 2012, with the 10-year yield just below 2%, as of this writing, Bloomberg quotes a yield of 3.2%).

Of course, I don't fault Tom Wolfe for not seeing this. Finance isn't his field, though he clearly researched it well for Bonfire (in the original serialization of the novel, the protagonist was, less ambitiously, a writer). Most likely, the bond market pros he interviewed as part of his research didn't see it either. It's hard to imagine a trend reversing when it has gone on for 30 or more years. Which is about how long it's been since Bonfire of the Vanities was published, and since we had that big inflection point in the bond market.

Of course, there are some market participants, such as the hedge fund manager Jeffrey Gundlach, who have argued that the 10-year yield going over 3%, as it has this year, is itself an inflection point. Time will tell if that was the case, but the good news for those holding the Vanguard Total Bond Market ETF (BND) is that it is inexpensive to hedge now. I'll show a way of doing so below, and then briefly discuss an alternate approach for investors with similar risk tolerances.

Hedging BND

If you're worried that a secular bear market in bonds may have already started, or may start over the next several months, here's a way you can limit your downside risk without capping your upside (the screen capture below is via the Portfolio Armor iPhone app).

As of Friday's close, these were the optimal, or least expensive, put options to hedge 1,000 shares of BND against a >7% drop by mid-March.

Image via PA.

The cost of this protection, as you can see above, was $150, or 0.19% of position value, calculated conservatively, using the ask price of the puts. In practice, you can often buy put options at some price between the bid and ask, so it's likely you could have purchased this protection for significantly less on Friday.

Another Approach For Risk-Averse Investors

Let's take a moment to consider the potential risk versus reward for a BND position hedged as above. Over the last ten years, BND has posted a total return of about 1.72% over the average 6-month period. The cost of the hedge above is equivalent to about 0.25% of position value, over a 6-month period. Assuming your hedging cost stays in that ballpark, your downside risk would be a drawdown of 7%, and your potential return, over time, net of hedging cost, would be about 1.47% over the average 6-month period.

An alternate approach giving you the same downside risk but higher potential returns would be to use the hedged portfolio method to construct a portfolio of securities hedged against a >7% decline. The ones I've run since July of 2017 have averaged returns of 5.98% so far, net of hedging and trading costs, as you can see in the screen capture from the Performance-Tracking Portfolios tab on the Portfolio Armor website.

If you're curious which securities were held in those portfolios, on the version of that table on the website includes interactive charts of each, showing their holdings.

If you think a higher potential return with the same downside risk of the hedged BND position is of interest, this alternate approach may be worthy of consideration.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.