Why bonds still matter in a low-yield world

March 8, 2021

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Time to reduce the ballast from bonds

Interest rates for most fixed income investments are at historically low levels. That means bond prices are correspondingly high. There isn't much more room for yields to fall, which means investors are unlikely to see robust total returns from bonds, at least for the next several years. It's no surprise, then, that investors and investment professionals wonder: Is it time to rethink the role of bonds in diversified portfolios, including target-date funds (TDFs)?

Reevaluating the pursuit of growth and income

In the traditional view, balanced investing seeks some combination of long-term growth from stocks along with income from bonds that can provide diversification and less price volatility.

Over the long term, U.S. stocks and most international markets have delivered their end of the bargain. Meanwhile, fixed income yields have drifted lower in recent decades—and so bond fund investors have enjoyed the growth in principal caused by falling yields—and therefore historically high total returns.

However, the benchmark 10-year U.S. Treasury note has yielded below 1% for most of 2020—an unprecedentedly meager level of income that is below the Federal Reserve's 2% target. Even the 30-year Treasury's yield has stayed below 2% since the COVID-19 pandemic hit the United States. Yields from corporate bonds are also at unusually low levels.

It's true that yields could sink further. After all, yields on U.S. Treasury Inflation-Protected Securities (TIPS) have been predominately negative for months, and even yields on 1-month and 3-month T-bills went underwater briefly in March.

Also, some non-U.S. bond markets have supported negative yields. In fact, the European Central Bank has kept its key lending rates below zero. Still, the Federal Reserve has expressed skepticism that it would facilitate nominal U.S. yields going below zero, which implies U.S. rates don't have much further to fall.

Meanwhile, the Fed has stated it doesn't expect to raise the federal funds rate above near-zero for the foreseeable future. So bond investors can rightly ask where they might find a higher stream of income that can more closely track or exceed inflation without taking on too much risk.

Figure 1. Lower interest rates have pushed expected bond returns lower over the next ten years

Lower interest rates have pushed expected bond returns lower over the next ten years

IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model (VCMM) regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modeled asset class. Simulations as of September 30, 2020, in USD for asset classes highlighted here. Results from the model may vary with each use and over time. For more information, see "Indexes for VCMM simulations" in the Notes section.

Notes: Median volatility is the 50th percentile of an asset class's distribution of annualized standard deviation of returns. Asset class returns do not take into account management fees and expenses, nor do they reflect the effect of taxes. Returns do reflect reinvestment of dividends and capital gains.
Source: Vanguard.

Living in a low-yield world

Today's low yields raise the question of whether bonds are so high-priced that they aren't as positioned as usual to cushion a portfolio if stocks nosedive. During past stock downturns, bonds often rose in price as investors shifted to less volatile asset classes.

Now that bond prices are so high, it's natural to ask how the bond market might respond to a future stock market downdraft. What if both stocks and bonds turn downward at the same time? Such an outcome, while potentially painful in the short run, would actually benefit target-date investors who stay the course. That's because reinvesting rising bond yields within a bond mutual fund can eventually produce total returns that can compensate for, or even exceed, the shorter-term principal losses. And as shown below, bonds' long-term performance has come mostly from income return, not price return.

Figure 2. Income has driven bond total returns over time

Income has driven bond total returns over time

Source: Vanguard. Returns shown are calculated from annual returns of the Bloomberg Barclays US Aggregate Bond Index from December 31, 1976, through December 31, 2020. All bond income is assumed to be reinvested. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

This benefit of reinvestment is just one reason the case for bonds as a natural diversifier remains valid. Whatever direction the markets take in the short or long term, bonds can still serve as ballast against one of the primary risks faced by balanced portfolios: stock market risk. As investors experienced in the fourth quarter of 2018 and the first quarter of 2020, stocks can plunge steeply for a time. In both cases, balanced portfolios saw their investment-grade bond allocations provide an important buffer.

Figure 3. Performance of stocks and bonds during two recent equity downturns

Performance of stocks and bonds during two recent equity downturns

U.S. stocks represented by CRSP US Total Market Index. Non-U.S. stocks represented by FTSE Global All Cap ex US Index. U.S. investment-grade bonds represented by Bloomberg Barclays US Aggregate Bond Index. U.S. high-yield bonds represented by Bloomberg Barclays US Corporate High Yield Bond Index. Non-U.S. investment-grade bonds (hedged) represented by Bloomberg Barclays Global Aggregate ex-USD Float Adjusted RIC Capped Index (USD Hedged).
Source: Vanguard.
Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

In addition to the diversification benefits high-quality bonds provide to a target-date fund, Vanguard Target Retirement Funds also feature a high level of diversification within their bond allocations. Vanguard follows a market-proportional approach in the U.S. nominal investment-grade bond market, providing investors broad exposure across sectors, qualities, and maturities. And unlike most TDFs, we also include an allocation to international investment-grade bonds. This gives our TDF investors exposure to a greater number of securities (7,000 plus), countries (40 plus), yield curves, and economic and inflation environments. Importantly, the factors that drive international bond prices are relatively uncorrelated to those that drive U.S. bond prices.

Importantly, our international fixed income assets are hedged back to the U.S. dollar, which minimizes the volatility of global currency fluctuations. These fluctuations, when unhedged, account for a significant portion of the overall volatility of the asset class. We believe our hedging is critical to maintaining the risk and return properties of the asset class.

Figure 4. The broad bond diversification within Vanguard Target Retirement Funds

The broad bond diversification within Vanguard Target Retirement Funds

Are there alternatives worth considering?

These time-tested diversification benefits from bonds hold true even as we acknowledge, as noted earlier, the increased likelihood of historically low bond returns going forward. Nonetheless, some investors still wonder: Are there prudent or reasonable investments that could be used in place of high-quality bonds to enhance diversification or increase income within TDFs?

The search for alternatives is not a simple task. There are inevitable trade-offs that must be considered. Here are some available strategies and their possible negative consequences:

  • Betting on interest rates. Making bets on the direction of interest rates by changing the duration of a bond portfolio from that of a broad market index adds an extra dimension of risk. Whether done through an indexed or active approach, such a move could potentially boost returns—but it could also do the opposite. Lengthening the duration of the portfolio is a typical temptation to gain higher yields, but it makes the portfolio more sensitive to rising interest rates, and thereby raises the risk of steeper principal declines. If such a strategy is implemented through an actively managed bond sleeve, investors should be aware of the level of active management risk they are comfortable with and have the patience to withstand periods of wider underperformance. And because active management is more expensive than index investing, the cost drag on performance is a constant factor. However, active bond management can be beneficial when executed carefully within certain parameters. Forthcoming Vanguard research will lay out the best ways active management can be implemented.
  • Lower quality/higher yields. Increasing the credit risk of the bond portfolio by investing in lower-quality, higher-yielding bonds—even venturing into emerging markets debt—tends to raise the portfolio's correlation with equities and therefore increases the likelihood of price volatility. As a result, high-yield bonds are likely to underperform right when the bond allocation could provide downside protection during a stock market decline.
  • Equity income. Devoting a portion of a fixed income portfolio to dividend-paying equities—including real estate investment trusts—in a quest for higher yields changes the risk profile of a balanced portfolio, making it more vulnerable to stock market risk.

The case for bonds is still solid

Taking the long-term view, it's clear that no matter what the stock and bond markets are doing in any given quarter or year, a diversified portfolio of investment-grade bonds remains the best way to provide some equilibrium for long-term balanced investments such as TDFs. Bonds have proven through every economic and market cycle to be reliable as a steadying influence in reducing the negative volatility that stocks inevitably experience from time to time.

And yes, while regularly reinvesting income from bonds—which TDFs do by their very nature—isn't providing as much of a boost as before, bonds' presence helps put investors in position to benefit when interest rates rise.

However, we never assume that history guarantees the future. Our ongoing research continuously evaluates the most sensible portfolio construction strategies for meeting investors' long-term goals, particularly those related to retirement. Those goals are not uniform among investors, of course. While some investors want to simply supplement other retirement income sources with a basic stipend for essentials, others may want to maintain a lifestyle that requires a higher level of income. Still others are more focused on leaving a legacy to heirs or other beneficiaries. We continue to consider strategies and tactics that can be implemented to best accommodate the variety of goals that retirement investors express.

Notes:

  • All investing is subject to risk, including the possible loss of the money you invest.
  • Investments in target-date funds are subject to the risks of their underlying funds. The year in the fund name refers to the approximate year (the target date) when an investor in the fund would retire and leave the workforce. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in the target-date fund is not guaranteed at any time, including on or after the target date.
  • Investments in bonds are subject to interest rate, credit, and inflation risk. Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. Foreign investing involves additional risks, including currency fluctuations and political uncertainty. Bonds of companies in emerging markets are generally more risky than bonds of companies in developed countries.
  • U.S. government backing of Treasury or agency securities applies only to the underlying securities and does not prevent share-price fluctuations. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest.
  • Diversification does not ensure a profit or protect against a loss in a declining market.
  • 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.
  • Please remember that all investments involve some risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
  • IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.
  • The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.
  • The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard's primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.

Indexes for VCMM simulation

The long-term returns of our hypothetical portfolios are based on data for the appropriate market indexes through September 30, 2020. We chose these benchmarks to provide the most complete history possible, and we apportioned the global allocations to align with Vanguards guidance in constructing diversified portfolios. Asset classes and their representative forecast indexes are as follows:

  • U.S. equities: MSCI US Broad Market Index.
  • Global ex-U.S. equities: MSCI All Country World ex USA Index.
  • U.S. REITs: FTSE/NAREIT US Real Estate Index.
  • U.S. cash: U.S. 3-Month Treasury—constant maturity.
  • U.S. Treasury bonds: Bloomberg Barclays U.S. Treasury Index.
  • U.S. short-term Treasury bonds: Bloomberg Barclays U.S. 1–5 Year Treasury Bond Index.
  • U.S. long-term Treasury bonds: Bloomberg Barclays U.S. Long Treasury Bond Index.
  • U.S. credit bonds: Bloomberg Barclays U.S. Credit Bond Index.
  • U.S. short-term credit bonds: Bloomberg Barclays U.S. 1–3 Year Credit Bond Index.
  • U.S. high-yield corporate bonds: Bloomberg Barclays U.S. High Yield Corporate Bond Index.
  • U.S. bonds: Bloomberg Barclays U.S. Aggregate Bond Index.
  • Global ex-U.S. bonds: Bloomberg Barclays Global Aggregate ex-USD Index.
  • U.S. TIPS: Bloomberg Barclays U.S. Treasury Inflation-Protected Securities Index.
  • U.S. short-term TIPS: Bloomberg Barclays U.S. 1–5 Year Treasury Inflation-Protected Securities Index.