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Reducing your bond allocation? Proceed with caution

May 07, 2013

Investment-grade bonds have had an extraordinary run over the last 30-odd years. Low interest rates, tame inflation, and—especially in the last decade—demand for a "safe haven" from volatile equity markets aligned in bonds' favor, producing a return of 8.2% on average per year from 1976 through 2012.*

But Vanguard believes future bond returns are unlikely to be as generous. After all, yields are now near historical lows, leaving little room for prices to rise (yields and prices move in opposite directions). And of course, low yields mean the income earned from these bonds is going to be low as well.

Bonds can play a useful role in almost any portfolio, but many people find them confusing.

We've created interactive illustrations to take away some of the mystery:

Overview: How do bonds work? »
Duration »
Maturity and stability »
The yield curve »

Note: These illustrations require Macromedia Flash software and may not be viewable on all devices.

Looming on the horizon is the possibility—likelihood is perhaps a better word—that as the U.S. economy strengthens, the Federal Reserve will return its interest rate targets to historically normal levels, with negative implications for bond prices.

Are investment-grade bonds still a keeper?

Given the low expected returns for investment-grade bonds, it's not surprising that some investors see greener pastures in alternatives such as high-yield bonds, high-dividend-paying stocks, or emerging market bonds.

A smart switch? Not necessarily.

Regardless of yield levels, we expect investment-grade bonds to continue to show a low performance correlation to stocks—a diversification benefit, especially during periods of sharp drops in the equity market, when investors value a cushion the most.

A recent Vanguard study looked at the implications of lower expected returns from investment-grade bonds. Our analysts conducted performance simulations that illustrated how lower returns from bonds would likely lead to lower overall returns for a balanced portfolio, while still offering a significant level of protection from downturns in the stock market.

Crunching the numbers

The two hypothetical scenarios below show how an allocation to investment-grade bonds could offset steep declines in the stock market.

In Scenario 1, if the stock market were to drop 20% over a 12-month period and investment-grade bonds were to return 7.3% (their historical average yield between 1976 and early 2013), a balanced portfolio with 60% stocks and 40% bonds would return –9.1%. The hypothetical investor's bond allocation would, in effect, offset 10.9% of the loss that his or her account would have experienced in an all-stock portfolio.

Scenario 2 also assumes a 20% decline in the stock market, along with much lower bond returns: 1.9%, which is today's current investment-grade bond yield. This would result in a lower return but still cushion the portfolio's fall by 8.8%.

  Scenario 1 Scenario 2
Stock returns: –20.0% –20.0%
Bond returns: 7.3% 1.9%
Total portfolio return: –9.1% –11.2%
"Cushion" from bond holdings: 10.9% 8.8%

Assumptions: 12-month total return for a broadly diversified portfolio with 60% stocks and 40% bonds. No change in interest rates.

Notes: These hypothetical scenarios do not represent the results from any particular investment. Scenario 1 assumes a forward-looking bond return of 7.3%, equal to the average historical yield to maturity of the Barclays U.S. Aggregate Bond Index from January 1, 1976, through January 31, 2013. Scenario 2 assumes a more conservative, forward-looking estimated bond return of 1.9%—the Barclays U.S. Aggregate Bond Index current yield to maturity as of January 31, 2013.

Consider changing your expectations, not your asset allocation

Investment-grade bond returns of 1.9% per year are far from what bond investors have become accustomed to. But unlike riskier investments (such as high-yield bonds, high-dividend-paying stocks, and emerging market bonds), investment-grade bonds are expected to continue to act as a counter to stock market volatility and provide downside protection in steep stock market sell-offs.

The bottom line: If you want more return than investment-grade bonds offer, you have to be willing to take on more risk. Low returns don't make the decision any easier—the trade-off is the same.

For a detailed look at the downside protection provided by investment-grade bonds under various return scenarios, view the Vanguard research paper Reducing bonds? Proceed with caution.

* Source: Vanguard, using the Barclays U.S. Aggregate Bond Index as a benchmark.

Notes:

  • All investing, including a portfolio's current and future holdings, is 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.
  • Unlike stocks and bonds, U.S. Treasury securities are guaranteed as to the timely payment of principal and interest. High-yield bonds generally have medium- and lower-range credit-quality ratings and are therefore subject to a higher level of credit risk than bonds with higher credit-quality ratings.
  • 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.
  • Note that hypothetical illustrations are not exact representations of any particular investment.
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