Fixed income markets are different from equity markets.

Let’s say that again.

Fixed income markets are different from equity markets.

This statement is absurdly self-evident when put into writing. But it’s not as obvious when put into the context of today’s market dynamics. A systemic shift toward index investing has conditioned investors to think of every asset class as an exchange-traded security and to think of every exposure as a directional call on an entire asset class. For many, the annual rebalancing going on right now is at least in part an exercise to decide if they think equities and/or fixed income will go up again in 2020. But what does “go up” really mean? The index revolution has eroded the distinctions between asset classes. It’s easy to forget that exchange-traded funds (ETFs) aren’t stocks; as with any fund, there are underlying securities whose prices are ultimately driven by their own unique math and subject to their own asymmetries.

For example, unlike equities, bonds do have quantitative upper bounds. For a bond, there is a calculable highest price. A bond won’t reasonably trade higher than the tightest yield investors are willing to earn. Even if that is zero (or in the case of some sovereign debt, negative1), the yield determines the maximum possible price. In that way, bond portfolios don’t have the same luxury as equity portfolios, blindly expecting a repeat of a prior year’s total return. Sure, the equity market might go up 31.5% again. We don’t think it’s likely, but it could happen. But the Bloomberg Barclays US Aggregate Bond Index (the “Agg”) was up 8.7% in 2019, and for investors to expect a repeat of this in 2020 is to ignore the fundamental, unassailable math that governs bond prices. We are not saying 2020 can’t be a positive year for fixed income. But we are saying that investors should probably trust the numbers.

For the purposes of this discussion, we will focus on the Agg as the most common benchmark for broad market fixed income. At the start of 2020, the Agg had a duration of 6.16 years, an average credit spread of 0.39% 2 and an average yield-to-worst3 of 2.31%. To give readers a sense of how these values compare to the past, Figure 1 shows three charts, one for each datapoint, over the last 30 years, along with interest rates for the 7-year Treasury note,4 which finished 2019 at 1.83%.

Figure 1: 30-year history of 7-year Treasury bond interest rates and the yield-to-worst, duration and option-adjusted spread for the Bloomberg Barclays US Aggregate Bond index. (Sources: US Treasury, Bloomberg Finance LP)

From here, the bond math takes over. The Agg’s performance, for the most part, is driven by the yield and changes in interest rates and credit spreads. The magnitude of the impact of those changes is determined by the duration.5 Of course, if nothing changes, the index should be expected to return the start-of-year 2.31% yield as a base case.