The bond market: Challenges ahead
March 25, 2013
Bond investors have enjoyed strong returns for years. But experience teaches that it's a mistake to expect the future to be exactly like the past.
A big part of what's driven the strong performance of bonds has been an increase in bond prices, which has driven yields to historical lows. (Bond yields and prices move in opposite directions.) Now, bond investors are receiving slender yields with little opportunity for further price gains. Add to that uncertainty about the effects of the Federal Reserve's unprecedented actions to hold down interest rates, and bond investors are facing a much less hospitable climate than the one they've been accustomed to.
In this interview, Vanguard Chairman and CEO Bill McNabb and Robert Auwaerter, head of our Fixed Income Group, discussed the challenges facing bond investors as well as the enduring role that bonds can play in a diversified portfolio.
What's your outlook for the broad U.S. bond market?
Bill McNabb: The one thing we can be fairly confident about is that the next ten years of bond returns aren't going to be what the last ten years have been, when the broad bond market returned about 5% a year. It's almost mathematically impossible because yields currently are so low.
The current yield of a bond is one of the best predictors of its future returns. So, logically, with yields near historical lows, investors should have much more modest expectations for bond returns. I'm not saying to investors that they should abandon a sensible allocation to bonds. I'm just trying to help set realistic expectations.
Bonds have an important part to play in a portfolio because of the diversification benefits they could provide. They also continue to be a source of income for investors. And if interest rates rise, we'll see a decline in bond prices but, over the long term, a rising rate environment is not a bad thing for people who are in it for income. If you're reinvesting part of the dividend, you'll reinvest at a higher rate and that will compound over time.
There's been a lot of discussion about the possibility for a bond bear market. Mr. Auwaerter, can you provide perspective on what bond bear markets have been like historically and how they compare with the severity of stock bear markets?
Robert Auwaerter: Clearly, bond bear markets have not historically been of the same magnitude as bear markets in stocks. In 1994, when interest rates spiked up and bonds had a very bad year, the broad bond market had a negative return of –2.9%. So nothing like the stock market in 2008 when there was a return of –37% for the year.
But it's also very important to look at these historical examples in context. A big difference between now and, say, 1994 is that yields are much lower than they were then. In the past, yields have helped offset declines in bond prices. But today we don't have that yield cushion. We are in a unique historical situation with bonds. I've worked in investment management since 1978, and I've never experienced yields this low. You have to go back to the 1950s to find yields at this level.
That does raise the question, given the concerns you've both outlined, of whether investors should make significant changes to the bond allocations of their portfolios?
Robert Auwaerter: There's probably always a temptation to try to time the market by making big, sudden changes. But I would just point out that history has shown that timing the market is very difficult to do successfully, whether you're talking about the stock market or the bond market. And keep in mind, as Bill noted, bonds could continue to serve as a diversifier in a portfolio.
Bill McNabb: To pick up on what Bob is saying, it's important to remember that each investment, each asset class, plays an important role in an overall portfolio. Generally speaking, stocks are there for higher expected returns. Bonds are there to help moderate the volatility associated with those higher expected returns and to provide income as well. Even though yields are low and return expectations are modest, investors can still think of bonds playing the same role that they always have.
From an individual's standpoint, when coming up with an asset allocation, or deciding whether to modify an existing allocation, it's wise to focus on your long-term goals—what it is that you're investing for and saving for—rather than let guesses about short-term market moves drive your decisions.
The Federal Reserve has taken steps to hold down interest rates, including buying hundreds of billions of dollars of bonds and mortgage-backed securities. How have Fed policies affected the bond market and when might the Fed start shifting course?
Robert Auwaerter: The Federal Reserve is acting as a very powerful depressant on interest rates and on bond yields. In addition to keeping short-term rates near zero, the Fed is buying an extraordinary amount of the Treasury securities that are being issued, and that has depressed longer-term bond yields.
The Fed has made it very clear that—provided there isn't a big, persistent rise in inflation—that it won't even begin to consider removing monetary easing policies until the unemployment rate improves to 6.5%. To get to that rate of unemployment, we would need a sustained jump in job growth. So we don't see the Fed changing course in the near term, and when the Fed does, we expect it'll go slowly so as not to undo the efforts made to keep interest rates low and to stimulate the economy.
There's a lot of attention on the Fed's monetary policy right now, but looking at it from a long-term perspective, it's very important the United States address its fiscal issues and begins to get its budget deficits under control. It doesn't have to be right away, but we do have to have a long-term credible plan on the budget deficit to maintain future stability in the U.S. Treasury market. As a country, we have to come to some solution on the deficit. That's very important to the long-term health of the bond market and our country.
An interesting phenomenon over the last several years is that investors have continued to channel money into bond funds even as yields declined. Are there lessons to draw from this trend?
Bill McNabb: In a sense, it's not surprising how much money has flowed into bond funds. Investors tend to focus on recent past performance. If you think back to the middle of last year, for example, the past performance investors were focusing on showed that bonds and stocks had very similar ten-year returns, a little less than 6% per year.* But the difference was bonds had done so with one-third the volatility of stocks. I'm not sure investors could tell you that precisely, by they certainly felt it.
So investors' behavior is understandable, but there are significant risks to chasing past performance. I'll come back to that point I made at the beginning: We do not expect the next ten years of bond returns to look like the last ten.
*As of June 30, 2012, the ten-year annualized return for the Barclays U.S. Aggregate Bond Index, a broad measure of the taxable U.S. bond market, was 5.63%; ten-year annualized return for the Russell 3000 Index, a broad measure of the U.S. stock market, was 5.81%
- All investments, including a portfolio's current and future holdings, are subject to risk.
- Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline.
- While U.S. Treasury or government agency securities provide substantial protection against credit risk, they do not protect investors against price changes due to changing interest rates.
- Past performance is no guarantee of future results. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
- Diversification does not ensure a profit or protect against a loss in a declining market.