Everyone knows U.S. interest rates are low and below historical long-term averages.
But one Vanguard expert says that—keeping in mind the double-digit rates of the ‘70s and early-‘80s, it’s “somewhat astonishing that the yields on a broadly diversified basket of high-quality bonds (whether Treasury, corporate, or municipal securities) are often now below 2% or 3%. Given the rise in prices for food, health care and other select goods and services, such an environment can rightfully be thought of as ‘financial repression,’ said, Ken Volpert (left), head of Vanguard's Taxable Bond Group, in an outlook report released Tuesday.
Volpert notes, with some alarm, that investors aren’t moving away from bonds and that they are even adding holdings in the sector.
“And I guess it’s hard to blame them,” he said. “With the stock market subject to nerve-racking volatility, bonds have seemed like a comparatively safe harbor in recent years. Since 2000, the broad U.S. bond market has produced a cumulative net return of 8.1%, versus 2.4% for the broad U.S. stock market.”
With current bond yields low, interest rates lower and the economic outlook “cloudy at best,” Vanguard says it “doesn’t think future bond returns will be nearly as robust as they’ve been. In fact, looking forward, we’re inclined to expect significantly elevated levels of volatility in the bond market.”
What’s Driving This?
“The Federal Reserve is forcing real interest rates into negative territory in order to reduce government and private debt burdens over the next decade,” Volpert explained. This has led to expectations of “very small returns, less than 2%” for Treasuries over the next few years, and “slightly higher returns, about 3%–4%,” for corporates.
The bond expert, who oversees more than 40 index and actively managed taxable bond funds with $375 billion in assets, says that when the Fed changes its tune and “stops promoting negative real rates, those bond returns will turn negative as real rates move back up to 1%–3% levels.”
In addition, he notes, the time to act is now. “I don't know if investors are aware of this outlook, but I would suggest they should understand the point we have reached and act accordingly,” Volpert said. “In addition, if the bull market for bonds means that investors' portfolios have developed a bond ‘overweight’ in recent years, it may be time to consider rebalancing back to their long-term target.”
Volpert’s colleague Tim Buckley, the incoming chief investment officer (set to replace current CIO Gus Sauter on Jan. 1), echoed this thinking in a summer commentary on fixed income: "Over the past 30 years, the broad U.S. bond market has produced a total return of 8.8% per year on average—a remarkable run,” shared Buckley in the outlook report. “Given today's low yields and the uncertain economic outlook (the bond markets do not like uncertainty), we don't expect bond market returns to maintain anything near that level going forward."
As for the difference between investing in actively managed bond funds vs. index funds, “low-cost, broadly diversified index funds should make up the portfolio's core,” Volpert explained. Active funds, he notes, “can bring out the worst behaviors among investors, who too often buy high when a hot fund reaches peak publicity, and sell low when the pain of negative returns has become unbearable.”
While Treasuries are often the diversifier of choice for investors, providing cushion during stock market downturns, “Investors need to be aware that this cushion has lost much of its spring,” Volpert said.
If an investor had bought a 10-year Treasury four years ago, he says, that individual would have enjoyed a cumulative return of 39% for the past four years. If the same investor buys a 10-year Treasury today, yielding 1.5%, the best he or she can achieve over the next decade is a cumulative return of 16%—not even half of the past four years' return, argues the Vanguard bond expert. “Of course, that is still a positive return, but much of the protection value against stock market declines has been wrung out of Treasury yields,” he concluded.
Time to Watch TIPs
Investor also need to pay attention to the limitations on Treasury Inflation-Protected Securities (or TIPS), which have a longer average maturity—roughly 10 years—versus that of the nominal Treasury market, seven years. “That means they have a longer duration, which has been helpful to TIPS as rates have declined but will be harmful when rates rise,” Volpert said.
Real interest rates—i.e., the current 10-year Treasury yield minus expected inflation—are currently at –0.5%, Vanguard says, below the average of 2.1% for the decade ended Dec. 31, 2010. Also, TIPS have an average duration of nine years.
If interest rates rise 0.5% to 1%, which is still well below the 10-year average of 2.1%, TIPS will fall 9%, according to Vanguard’s analysis. “With a starting real yield of –0.5% and inflation at 2%, it would take six years of inflation income to make up that principal loss,” Volpert said.
Investment-grade corporate bonds, on the other hand, have been yielding 150 to 200 basis points more than U.S. Treasuries, the expert points out, “so we think they can be a good strategy for generating income.”
Plus, if—or when—interest rates start rising, Vanguard experts “see the spreads over Treasuries tightening but remaining attractive,” he points out.
As for Vanguard’s corporate-bond products, the firm has three corporate ETFs with more than 850 holdings in each, according to Volpert, “and we think having broad exposure to this market can help reduce issuer-specific risk and more fully capture the corporate bond risk premium. If we continue in a slow-growth environment, we think investment-grade bonds can hold up well. If we move into a mild recession, we see the sector producing modestly weak returns.”
His group is less optimistic about high-yield strategies, “which will show volatility similar to stocks if we are facing a recession or a breakup of the euro.”
He acknowledges that these products “are popular with advisors” and caution advisors to consider mutual funds instead of ETFs for this sector.
“The reason is the liquidity of the underlying bonds. When high-yield bonds are doing well and cash flow is positive, investors in ETFs are typically paying a significant premium over NAV in the less transparent, less liquid market for below-investment-grade bonds,” he explained.
“When high-yield bonds are declining and cash flow reverses, investors could face not only the disappearance of that premium, but also a discount to NAV when selling the ETF,” Volpert warned. “For ETF investors it’s really important in this segment of the market not to trade with the crowd because the crowd will bear the brunt of these premium-to-discount swings.”
More on Mortgage-Backed Securities
Vanguard invests in bonds backed by Fannie Mae, Ginnie Mae and Freddie Mac, because they are under the conservatorship of the Treasury Department, “reducing credit risk,” Volpert says. “We overweight MBS in our Treasury funds because higher-coupon mortgages are staying outstanding much longer, leading to attractive yields in this very low-rate environment.”
The risk of refinancing these higher coupons has declined for a number of reasons, which, in today’s market, means the prices for MBS are getting bid up as investors look for yields above those on Treasuries. “This has reduced the yields on MBS, but there is still a pickup over Treasuries. We also anticipate a boon for this segment if the Federal Reserve buys MBS in the next round of quantitative easing,” he concluded.
What to Do
In terms of the right strategic response, Vanguard suggests investors have “the right asset allocation” based on their particular investment timeframe, financial goals and risk tolerance.
Some bond investors may want to stick with their current allocation, while others may find it’s “a good time to rebalance back toward equities,” Volpert explained.
He notes that there are several broad schools of thought on how to approach today’s bond market, according to investment experts and commentators:
1. Low interest rates imply low future bond returns.
2. Be wary of blind devotion to “mean reversion.”
3. Be wary of “cherry-picking” history.
4. Treat the future with the humility it deserves.
While it may not make Vanguard popular with market bulls, the fund shop’s recent outlook cautions investors and advisors not to discount the fact that the United States could—like Japan—experience a “lost decade” of equity-market performance, though the odds of such a scenario are low.
“And even assigning a small probability to a Japan-like outcome can often lead one back to a broadly diversified stock/bond portfolio. That is perhaps the best history lesson of all,” according to Volpert.