How Deep and Long Can Drawdowns in an Aggregate Investment Grade Bond Portfolio Last?

Today’s data research probably concerns those folks who invest in constant-duration fixed income bond funds.

This is probably not for those who bought bond funds where the fund managers actively buys and sells bonds based on their forecast opinions on the market, searching for mispricing in bonds.

If you are an investor in:

1. iShares Core Global Aggregate Bond UCITS ETF – USD Hedged (AGGU)
2. Amundi Index Global Aggregate Fund – SGD Hedged

To a certain extent, I think this would cover:

1. Dimensional Global Core Fixed Income Fund
2. Dimensional Global Core Fixed Income III Fund

The Dimensional funds are a systematic active fixed income strategy but do have to maintain a constant-duration that is not too far from their benchmark index, which is the Global Aggregate Bond index so this kind of will be apply to them.

These constant-duration fixed income funds have the following characteristics:

1. Very diversified fixed income holdings.
2. Roughly 8 years in average maturity.
3. Roughly 6 years in average duration (duration measures the sensitivity of the portfolio to a change in interest rate).
4. Averages to Investment Grade rating.

The rest of the attribute is less important because they fluctuate based on when we are discussing this.

I think many investors who have invested in fixed income are a bit disappointed for the past few years. Their returns have not been good and I think readers have heard me describe what they went through as the “Great Depression” in fixed income. This is because the magnitude of the drawdown can be liken to the magnitude of drawdown of equities in the 1929 crash where equity went down as much as 86% if we measure on a daily timeframe.

I think the volatility and returns has affect how you would look at the staple fixed income recommendation.

This is not surprising because most of us extrapolate what we experience recently as what you will ALWAYS experience if you keep investing in this.

If we take a look at more data, it might allow us to re-adjust our lens about the volatility of the global aggregate bond index.

If drawdown and recovery is a concern for many, how bad are the past drawdowns.

I thought of using the Global Aggregate Bond index but decide to use the US Aggregate Bond Index. The US Aggregate Bond index is a good proxy to analyze the volatility profile because it has the same maturity, duration and credit mix (slightly better).

The US Aggregate Bond Index starts in 1976 and we have 48 years of fixed income data where we can see just how bad can a constant-6-year-duration fixed income portfolio be.

While this is post-war, this period includes the tail end of the period where we all know interest rate went up to a very high level. That should be quite a challenge for a fixed income portfolio.

How Deep Are the Drawdowns for the US Aggregate Bond Index?

There are 587 months from Jan 1976 to Nov 2023, or nearly 48 years.

In this 587 months, there were 70 drawdowns.

What is my definition of a drawdown?

Suppose the price of the index reached a peak of $100. Then after some months, it goes down to $70 and then after some months it rose back to $100. I call this one instance of a drawdown. The deepest drawdown is 30% because the deepest you have an unrealized loss is 30%. We measure the duration as the time it takes to fall from the peak until it recovered back to the peak.

So here is the table of all the 70 instance of the drawdowns:

The date coincides with the end of the drawdown. Deepest drawdown show how deep the drawdown got and End Duration show how long in months is the drawdown.

One thing you will notice is that the recent “Great Depression” in bonds didn’t show up. That is because we haven’t recovered yet.

Here is the info for this challenging drawdown:

1. It started in Aug 2020
2. The deepest drawdown is 17.2%
3. The duration of drawdown is 52 months or 4.3 years
4. We are 7.1% away from recovery

This looks bad but had you invest before this, you really got hit with something that has not shown up in the data. That is also some info.

I think it is easier if we see the deepest drawdown and the duration in buckets:

The first chart here group the drawdown in various buckets. You would notice that almost 60 of them are less than 3.4% in magnitude. 8 of them are between 3.4% to 5.1%.

There were two instance where the magnitude is 10% or more. Those happen in 1980 and 1981.

This bar chart groups the 70 instances based on how long it takes to recover. Majority of them take less than 1 year with 8 instances taking more than a year to recover. 5 of those instances take more than a year to recover 3.7%.

There can be a few takeaways:

1. Majority of the drawdowns are small in magnitude and recover fast.
2. Instances like the recent fixed income drawdown is the more uncommon than the common ones.
3. If the duration is 6 years on average, the minimum time horizon that you should have to invest in such a bond fund is 6 years.
4. Despite this long duration, almost all 70 instances recovered within 2 years except this time round.
5. While deeper drawdowns are uncommon they are significantly less than the deeper equity drawdowns. Having the fixed income in the portfolio makes the investment experience more livable.

Recent experience will leave a bitter aftertaste and I have some friends wondering why do we bother with this when we can invest in equities or put in high yielding cash instead.

We are quite experiential creatures and I think there will be a time when there is a deep 20% equity drawdown which make you wonder have you over allocate to equities or when you find it extremely challenging to get a good yield for you cash. But after a while you would forget that as that equity/cash recovers. Sometimes, it gets more challenging because the drawdown last for years.

If you want to know why we had a “Great Depression” in bonds, it is when the majority of the people prefer to buy bonds when the valuation of bonds leans towards very expensive. And now at near 4.5% yield to maturity, we are disgusted with that.

Everyone reads the books and silently tell themselves they will be the one buying at depress prices, won’t be the one buy at expensive prices will now feel the uncertainty and the disgust about owning some intermediate duration fixed income. It is the same as when equities present the opportunity itself.

There will be enough talking heads saying this time is different. You look at the past 4 years return and think it is shit and you would rather be in cash.

The weird thing is that some people know that there is a Great Depression in equities but choose to invest in the S&P 500 but given this in fixed income they would not look at it. Am quite certain is the recency bias but also that people would accept that risk because the potential pay-off is pretty good. Secretly, they have a confidence the Great Depression in equities won’t happen during their time. But it is kind of ironic we just had this in fixed income yet they are so confident it won’t happen in equities.

I guess human behaviors doesn’t change too much.

Fixed income has its own unique behavior that is different from equities. Each fixed income, unless default will return you the principal. As a bond or note that has an unrealized loss goes closer to the maturity, the price of the bond or not goes back closer to par value. So It does not lose money if you don’t go so far out in the credit risk spectrum.

What you missed out on is the opportunity cost. The most extreme illustration of the opportunity cost is that those who bought in 2020, locked in 20 year maturity fixed income at 1.5%. If they sell, they have realized losses, but if they hold on and the issuer doesn’t default, they get back their capital. The same fixed income may yield 5% today, so that is opportunity cost lost.

If you are investing for a longer term, it is hard to estimate how much opportunity cost you will lose or you will gain instead of lose.

And this is one aspect that people lose their heads over it.

Constant Duration Fixed Income portfolios tend to do better when fixed income volatility is lower, which in an indirect way infers that they do better in an environment where liquidity is better. A look at the MOVE index, or the ICE BofAML US Bond Market Option Volatility Estimate Index, would show you that since end 2021, we are in a higher bond volatility regime that has not since come down.

But for long term fixed income holders all these should smooth itself out. That is your advantage.

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Kyith is the Owner and Sole Writer behind Investment Moats. Readers tune in to Investment Moats to learn and build stronger, firmer wealth foundations, how to have a Passive investment strategy, know more about investing in REITs and the nuts and bolts of Active Investing.

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Kyith worked as an IT operations engineer from 2004 to 2019. Currently, he works as a Senior Solutions Specialist in Insurance Start-up Havend. All opinions on Investment Moats are his own and does not represent the views of Providend.

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