The Independent Market Observer

Looking at Future Bond Returns

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Jul 26, 2016 12:56:27 PM

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bond returnsYou’re probably familiar with the standard investment disclaimer “Past performance is no guarantee of future results.” In other words, just because something worked in the past is no reason to assume it will work in the future. This is true: asset classes, in particular, tend to outperform and underperform in regular cycles.

Still, much financial industry marketing, reporting, and analysis focuses on what just happened. For example, Morningstar ratings, which are based on how a fund has done in the past, are routinely featured in mutual fund ads, as are past returns. Time and again, investors buy the most recent outperformer, only to see it drop off.

The problem is that outperformance in one part of the market cycle can often lead to underperformance shortly thereafter, as the cycle turns. In the short term, focusing on what just happened can lead to trouble. Investors, if you remember, were extremely confident in 1987, 1999, and 2007. In the long run, that worked out, but in the short run . . . not so much.

To try and avoid that kind of roller-coaster ride, you have to look ahead, not backward.

A forward-looking approach to investment management

The best way to achieve this is to review the fundamentals underlying returns. To say that stocks will return a certain percentage, without considering the price paid or the business conditions supporting that return, is an incomplete analysis. To use history as a guide is to assume that the future will be like the past—something we’re specifically enjoined not to do. We need to dig deeper.

To get an idea of what this means for returns in our future, let’s take a look at today’s fundamentals. To do this, we need to consider where returns come from: income (in the form of dividends for stocks and coupon payments for bonds) and capital gains, when the value of the asset itself increases.

What kind of bond income can we expect?

For most bonds, income is pretty straightforward because it is contractually specified. You get a payment of so many dollars every period; then, at maturity, you get paid the face amount of the bond. Barring financial problems at the borrower, that’s it. You have to decide how much you will pay for that fixed stream of income, but once you make the purchase, your return—barring default, and assuming you hold the bond until it matures—is fixed at the point of purchase.

For the Barclays U.S. Aggregate Bond Index, that return would be just under 2 percent as I write this. (That’s what you would make if you bought and held that portfolio of bonds.) Prospective global bond returns are even lower.

Bonds could do better than that, of course. If interest rates continue to decline, investors will be willing to pay more for that same stream of income, and the value of the bonds could rise. This is exactly what we have seen, overall, for the past 30 years. Bond returns have been well in excess of the coupon payments, as investors have bid up the values. Capital gains have added to income returns, and total returns from bonds have been quite strong.

Possibility for higher returns (but also for losses)

If we look at history, bonds have done much better than the 2-percent return we now anticipate. Based on past performance, we would expect interest rates to continue to decline, generating bond returns higher than 2 percent. But will this happen?

It could. And yet, with interest rates at 500-year lows, according to some sources, there’s also a real possibility that rates could rise—in which case, that 2-percent return would drop, potentially handing a loss to any investor who had to sell. Depending on how much interest rates change (declining further from current lows or rising back to historical norms), your actual return could be somewhat higher or much less than 2 percent.

In other words, although history suggests strong returns, it also suggests that rates should rise, which would lead to losses. Given where rates are, the fundamentals point out the real possibility of losses while also highlighting the very strong assumption that has to be made to support continued historical returns.

It’s not that simple, of course, and bonds continue to be a key building block of most people’s portfolios. But investors should be aware of the risks and modify their expectations accordingly.

What about stocks?

Stocks have the same problem, to an even greater degree. Tomorrow, we’ll apply this kind of analysis to the stock market, and Thursday, we’ll consider just what we can do about it.

The purchase of bonds is subject to availability and market conditions. There is an inverse relationship between the price of bonds and the yield: when price goes up, yield goes down, and vice versa. Market risk is a consideration if sold or redeemed prior to maturity. Some bonds have call features that may affect income.

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