“Even with the U.S. Federal Reserve’s latest interest rate hike on July 26, it’s hard to overstate the significant change in policy stance over the last year,” Vanguard senior U.S. economist Josh Hirt said. “For bondholders, this has put downward pressure on bond prices in the near term, but it likely results in higher total returns looking forward.”
The recent rise in rates has been hard on bondholders
Globally coordinated policy responses to generationally high inflation have pushed down bond returns across all major fixed income markets.
In the United States, where the Fed lifted short-term interest rates from near zero to well above 4% last year, the total 2022 return from investment-grade bonds was –13%, as measured by the Bloomberg U.S. Aggregate Bond Index. Comparable bonds outside the U.S. didn’t fare much better, returning –10%, as measured by the Bloomberg Global Aggregate ex-USD Index Hedged.
Long-duration U.S. Treasuries—one of the best-performing areas of the bond market over the prior decade—were particularly hard hit in 2022, returning –29%.
The silver lining: Higher expected returns over the long term
“Bond investors have been plagued over much of the past decade by historically low returns,” Vanguard investment strategy analyst Ian Kresnak said. “And the recent sell-off was especially hard to stomach for investors nearing retirement or those already in the decumulation phase. But given the rise in interest rates, they can now reinvest cash flows in bonds with higher coupons.”
The first figure shows the brighter outlook, as a $100 investment in U.S. bonds made on December 31, 2021, has a median projected value in 10 years’ time of $122.
Aggressive interest rate hikes that began in March 2022 have dragged down bond prices, but they’ve improved the outlook for fixed income returns. Because of higher starting yields, a $100 investment in U.S. bonds made on June 30, 2023, would have a median projected value in 10 years’ time of $133, or about 9% higher.
Bond investors are likely to be better off because of—not despite—the recent sell-off
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 December 31, 2021, and June 30, 2023. Results from the model may vary with each use and over time. For more information, please see the “Important information” section at the end of this article.
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.
Notes: The chart shows actual returns for the Bloomberg U.S. Aggregate Bond Index—along with Vanguard’s forecast for cumulative returns over the subsequent 10 years—as of December 31, 2021, and June 30, 2023. The dashed lines represent the 10th and 90th percentiles of the forecasted distribution. May 31, 2021, is before the market started to price in Fed rate hikes.
Sources: Vanguard calculations, based on June 30, 2023, VCMM simulations and data from Bloomberg.
Where rates may be headed
Some financial market commentators say fixed income is looking attractive now because the Fed is nearing the end of its hiking cycle.
“We would expect rates to remain elevated in restrictive territory for some time,” Hirt said. “That’s backed up by the ongoing resilience we’re witnessing in the labor market, housing, and consumer spending, but our outlook expects the largest policy adjustment to be behind us.”
How to invest in this environment
On the surface, a tilt toward short-term fixed income securities such as 3-month U.S. Treasury bills might seem to make sense given their attractive yields at the moment.
But for investors with any sort of meaningful time horizon, the high returns on such securities could prove fleeting. Their starting yields say much less about how they will perform over the long term than do the starting yields of longer-term bonds because their coupons reset much more frequently. (Short-term bonds also tend to have a higher correlation with equities, making them less of a risk diversifier than longer-term bonds.)
That difference in return predictability over the long term is illustrated in the next figure, which shows the relationship between the starting yield and future 10-year annualized returns for 3-month Treasury bills and 10-year Treasury notes.
Starting yields are much less predictive of 10-year returns for short-term securities
Past performance is no guarantee of future returns.
Notes: The first chart shows the relationship between the starting yield on 3-month constant maturity T-bills and their subsequent 10-year annualized return. The second chart shows the same relationship, but with the starting yield on 10-year Treasury notes and their subsequent 10-year annualized return. Data as of June 2023.
Sources: Vanguard, based on data from the Federal Reserve Bank of St. Louis, Robert Shiller’s online data, and Global Financial Data from September 1981 through June 2023.
So why not take a tactical approach and hold short-term fixed income securities as long as rates are high? To do that, an investor would need to get a lot right:
- Enter the trade sufficiently early so as to get an attractive price, but not so early as to experience “negative carry” associated with the market maintaining a different view for some time. (Here, negative carry would mean holding securities for which the decline in price exceeds the income generated.)
- Exit the trade at or near the trough for yields.
- Know that the magnitude of the anticipated rate decline would suffice to offset any associated taxes or costs.
“Regardless of where the Fed goes next,” Kresnak said, “disciplined investors with a clear goal and a plan to achieve it should be well-positioned to benefit from a return to more normal interest rates and equity valuations.”
Josh Hirt, CFA
Vanguard Senior U.S. Economist
Ian Kresnak, CFA
Vanguard Investment Strategy Analyst
All investing is subject to risk, including possible loss of principal.
Investments in bonds are subject to interest rate, credit, and inflation risk.
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 Vanguard Capital Markets Model® 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 VCMM 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.