Vanguard’s latest economic and investment outlook says the outlook for fixed income returns remains positive but muted. What’s the thinking behind that expectation?

If you want an idea of what bond returns are going to be like, a really good indicator is starting valuations. The yield of the Barclays U.S. Aggregate Float Adjusted Index is about 2.2% [as of the end of February]. So the best estimate of what the returns will be for a broadly diversified fixed income investor over the next ten years or so is around that level. If you think back ten or 15 years ago, starting yields were much higher—upward of 5% for that index—and, as a result, you saw much higher returns from your investment in bonds in the years that followed than you’re likely to see for a while. So starting valuations absolutely matter when it comes to return expectations for bonds, just as they do for stocks.


Do you expect bonds to produce negative returns in the short term?

Not necessarily. Although the Fed has started to raise rates, which pushes bond prices down, concerns about global growth and the collapse in commodity prices—especially for oil—are likely to make further rate increases very gradual. And as we’ve said, yields are low, but they may provide enough of a cushion if rates rise slowly enough over this tightening cycle to keep returns in positive territory. Keep in mind that rising rates are not a bad thing for long-term investors. Coupons and maturities get reinvested at higher yields, resulting in higher long-term returns.


Should such low yields influence investors’ allocation to bonds?

Bonds play a key role as a diversifier for the riskier assets in your portfolio, so you first need to be clear about the overall level of risk you’re comfortable with. Then look at all the asset classes you hold—stocks, bonds, and cash—and make sure your bond allocation puts you at the risk level you set for yourself.


There’s been a lot of speculation in the financial media that rising rates could lead to a wave of investors wanting to sell, but with no buyers. Are you worried about liquidity in the bond market?

First, I’m not convinced that rising rates will send bondholders rushing for the exits. Unlike some stock market participants, bond investors tend to follow a buy-and-hold strategy because they hold bonds for safety, diversification, or income. And those qualities don’t disappear if interest rates rise. And, as I mentioned, higher rates will mean higher returns down the road for bond investors. Keep in mind, too, that individuals who stick to a set asset allocation as well as investors in target-date funds and balanced funds will all become bond buyers if prices drop. So we would expect portfolio rebalancing to act as a stabilizing force in case of a sharp sell-off in bonds—an event that history would tell us is unlikely to happen.


We’ve been discussing the U.S. bond market, but what about the outlook for international bonds and their role in a portfolio?

Diversification is a good thing. That’s true in domestic bonds, certainly. Having at least some exposure across U.S. Treasury securities and the various segments of the corporate bond market makes sense for a couple of reasons: It ensures that you’re not left out when a part of the market does well, and also that you don’t find yourself having all your holdings in a segment that significantly underperforms. The same premise holds true for investing in bonds outside the United States. International bond markets operate under monetary policy set by central banks in response to those countries’ economic growth levels and local expectations for inflation. Those factors influence the shapes of the yield curves in those markets and how they move. So international bonds won’t necessarily be on the same path as U.S. bonds, and that’s where the diversification advantage comes in. How much international bond exposure is enough? Typically, what we’ve seen is that you get the most diversification benefit by going up to about 30% of your total allocation to bonds. Keep in mind, however, that your international bond exposure should be hedged. That’s because the currency risk associated with bonds that are not denominated in U.S. dollars can easily overwhelm the returns they produce.


Vanguard offers bond index funds as well as actively managed bond funds. How should an investor choose between them?

As with stocks, index funds could be a good choice as core holdings in a portfolio. And actively managed funds can be a nice complement if an investor wants to overweight a certain market sector or is looking to add value relative to a benchmark. Active funds give investors an opportunity to outperform, whereas the pure indexing model is simply about trying to capture the performance of the benchmark. So we don’t view it as either/or—you could actually use both.


We sometimes talk about bonds as if they’re all the same. Can you talk in general terms about the trade-off between yield and risk?

The key risk factors for bonds are interest rate risk, credit risk, and what we call convexity risk. Interest rate risk is the risk that a bond’s value will change because of a rise or fall in interest rates. Bonds with longer durations have greater interest rate sensitivity, meaning their prices are affected more by a given change in rates than bonds with shorter durations. It’s more intuitive than you might think: If you’re lending money to the U.S. government for a five-year period, you might demand a certain level of payment; but if you plan on lending it money for ten or 30 years, you’d expect to be paid more, because you’re in essence locking your money up for a long period. So duration really reflects how long you’re lending your money out, and that ultimately points to how sensitive those securities are to price movements. With credit risk, you’re in essence taking on the risk that the issuer might default. There’s really no credit risk if you’re investing in Treasuries; they’re considered risk-free because they’re backed by the full guarantee of the U.S. government. But when it comes to bonds of corporations or governments outside the United States, there’s some probability they might not be able to pay you back on time or at all, so they carry some credit risk. As you go down the credit-quality spectrum from companies or countries with AAA credit ratings to those with ratings of A or BBB, you’re taking on increasingly more credit risk. If you go even lower than that, you get to non-investment-grade bonds, also known as high-yield or junk bonds. In the marketplace, investors expect to be compensated for the degree of credit risk they take on. So you’d typically see higher yields from lower-rated bonds, because you’re taking on a greater risk that the issuer might not be able to meet its obligation of paying coupon and principal payments on time or at all. The last factor, convexity risk, is primarily associated with mortgage-backed securities. Borrowers who take out mortgages can repay them early, and they tend to do that most often at precisely the time you don’t want your money back—when interest rates are falling. So if you might be repaid your principal in an environment where you’re able to reinvest it only at a lower rate, you want to be compensated for taking on that risk. Basically, what you need to keep in mind as an investor is that there’s no free lunch: Bonds offering higher yields generally carry more risk in one form or another.


Do investors have misconceptions about the role bonds play that can lead to unintended outcomes, or even hurt the performance of their portfolios?

One mistake some retirees make is thinking they have to live off the income their portfolios generate. That can lead them to rejigger their portfolios to produce more income without regard to the added risk involved. When interest rates dropped during the financial crisis, some retirees who saw the income from their portfolios dropping tried to compensate by moving out of shorter-duration bonds into longer-duration bonds with higher yields. Others moved into lower-quality bonds, or even migrated out of bonds into high-dividend-yielding stocks and REITs [real estate investment trusts]. With all those moves, investors were—maybe unwittingly—taking on more risk. I would caution against letting your need for income dictate your bond strategy. Selling some of your assets can be a better way to get extra income if it helps your portfolio maintain a risk level that lets you sleep well at night.

Notes:
All investing is subject to risk, including the possible loss of the money you invest. Past performance is no guarantee of future results. Diversification does not ensure a profit or protect against a loss.

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.

There are additional risks when investing outside the United States, including the possibility that returns will be hurt by a decline in the value of foreign currencies or by unfavorable developments in a particular country or region.

For more information about Vanguard funds and ETFs, visit vanguard.com or call 800-662-7447 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.