Government bond yields’ steady downward trendSome countries' bond yields have fallen below zero (Japan, Germany, Switzerland). Yields of other developed countries, like Canada, Italy, the U.K., and the U.S., have also been declining and are now under 2%.

Sources: Vanguard, using Bloomberg monthly data for 10-year government bond yields for October 2009 through October 2019.

Although prospects for bond returns have dimmed as yields have fallen, it’s important to remember the role that bonds play in a portfolio, Vanguard experts Paul Jakubowski and Alexis Gray note.

A quick look at how we got here

Since the global financial crisis, central banks have cut their targets for short-term interest rates, seeking to make borrowing cheap in hopes that consumers and businesses would boost economic growth by buying cars, taking trips, hiring more workers, or investing in equipment. These short-term rate cuts can weigh on longer-term yields as well when investors interpret them as a sign that policymakers are worried about the economy’s health.

Paul Jakubowski

Investors buying bonds in anticipation of even lower yields have also played a role. After all, bonds’ prices rise when yields fall. So even bonds with negative yields can generate positive returns. “To realize a positive return, an investor must opportunistically sell the bonds prior to maturity, which may not be desirable or feasible for some investors,” said Jakubowski, Vanguard’s head of global fixed income indexing.

Alexis Gray

Fear has also driven yields lower, said Gray, a Vanguard senior economist. Some risk-averse investors—worried about the prospects of an economic slowdown or lofty stock valuations, for example—have chosen bonds’ near-zero returns over the risk of a significant stock market downturn of 10%, 20%, or even more.

Where yields might go, and what investors should consider

Yields are already low, but uncertainty about global growth and trade tensions in particular could well result in further easing by central banks. So it’s a difficult call. Yields could rise and normalize—or continue to go lower.

Because yields are a good proxy for bonds’ potential annualized rate of income, the bond environment is likely to remain challenging. Jakubowski and Gray offer some tips on how to navigate it:

  • Diversify globally. Negative yields in some markets shouldn’t deter investors from holding a global bond allocation. “If the exposure is hedged, the income return along with the resulting hedge return tends to produce total returns in line with those of local bonds but still offer the benefits of diversification,” Jakubowski said.
  • Resist the urge to reach for yield. Tilting your portfolio away from high-quality bonds for investments with potentially higher yields might be tempting in this environment, through either lower-quality bonds or high-dividend-yield stocks. More yield and more risk are a package deal, however. “Keep in mind why high-quality bonds are in your portfolio in the first place,” Gray said. “Their primary role is not to boost your portfolio’s return, but to act as a cushion for the higher volatility and downside of the riskier assets you hold in your portfolio such as stocks.”
  • Be realistic. Base your financial goals­­—such as sending your children to college or providing for your retirement—on realistic return expectations, Jakubowski cautioned. Starting to save if you haven’t already, saving slightly more of your pay every month, or extending your time horizon by, for example, planning to work a little longer are all more reliable ways of meeting those goals than counting on a hoped for level of market returns.
  • Keep an eye on costs. All else being equal, well-designed, low-cost investments provide more of an asset’s return to investors. By simply keeping costs low, you can boost income without an increase in portfolio risk.

Notes:

All investing is subject to risk, including the possible loss of the money you invest.

Diversification does not ensure a profit or protect against a loss.

Investments in bonds are subject to interest rate, credit, and inflation risk.

Investments in bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.