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September 25, 2012 at 08:00 PM
With current bond yields low, interest rates lower and the economic outlook “cloudy at best,” Ken Volpert, head of Vanguard’s Taxable Bond Group, says the organization “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.”
“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 in a recent outlook. 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. “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.
Corporate Bonds
