Core government bond yields may have mostly risen since mid-2012 but they are still very low by historical standards. This, together with concerns about further yield increases, has led some investors to question the case for holding bonds. We believe that these investors could usefully remember some important points about fixed income.
It’s true that bond returns over the next 10 years are unlikely to match those of the previous ten. Analysis shows that the current 10-year yield is a good predictor of future bond returns (see figure 1), and the current 10-year gilt yield of 2.6 per cent falls well short of the annualised return of 5.6 per cent that gilt investors have seen since 2004.
Figure 1: Today’s yield is a good predictor of future returns
Source: Vanguard
By comparison, Vanguard’s analysis suggests equity returns are likely to fall in the 6 to 9 per cent range over the next few years. So, from a performance perspective, there seems little reason to hold bonds.
But investors who are holding bonds to maximise performance are forgetting that recent times have been an anomaly. Over the long term, it’s normal for bonds to provide lower returns than equities.
Historically, it’s the low correlation between bonds and equities and the downside protection provided by bonds that has drawn investors to fixed income – and those characteristics remain just as true today as they ever have.
Figure 2: Bonds are for diversification and downside protection, not performance
Source: Vanguard
The correlations between bonds and equities are low and negative, especially during periods of equity market stress, making bonds an excellent diversifier for equity-heavy portfolios.
Not that there is a guarantee that equities will do well when bonds perform poorly. In fact, during some bond bear markets, equities have delivered bigger losses than bonds. The narrower spread of returns that bonds deliver is a key contributor to the long-term allure of fixed income.
Of course, bonds are also an important source of income, and recent low gilt yields have tempted some investors to look to corporate bonds, high yield bonds and even dividend equities in search of income.
These strategies can often achieve higher yields in the short term, but investors should appreciate that higher yields normally come with other risks attached.
Figure 3 shows the performance of a range of asset classes during equity bear markets. These are the times when the diversification benefits of bonds should be most keenly felt.
However, the chart shows that investors who were tempted into alternative high-yielding asset classes would have missed out on this diversification benefit.
Figure 3: Reaching for yield can leave investors exposed to capital loss
Source: Vanguard - Past performance is not a reliable indicator of future results.
So, in summary, even though bond markets are likely to provide lower returns in the next 10 years than they have in the last 10; and even though equities are likely to outperform bonds over the medium term, bonds still play an important diversification and risk dampening role in portfolios.
Investors should remember the long-term appeal of bonds and resist the temptation to turn their back on the asset class.
Important information
This article is designed only for use by, and is directed only at persons resident in the UK. The information on this document does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this document when making any investment decisions. The material contained in this document is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so.
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested. Past performance is not a reliable indicator of future results.
Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.
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