July 25, 2022 | Vanguard Perspective

Why your clients shouldn't abandon bonds

Matt Sheridan

Matt Sheridan
Senior Investment Consultant, Vanguard Portfolio Analytics and Consulting

"The first half of the year was a rough time for bond investors, with prices falling as yields climbed," said Matt Sheridan, senior investment consultant with Vanguard Portfolio Analytics and Consulting.

Bond prices may not matter as much as your clients think they do

"While swift bond price declines are upsetting to clients," Sheridan said, "it's important to remain focused on the long-term benefits of higher rates."

Bond total returns have two main components: price return and return from income. Changes to interest rates cause these two components to move in opposite directions. Medium- to long-term investors should care more about bond total returns instead of the negative short-term impact on bond prices. In fact, as we show in the chart, the long-term performance of bond investments has come mostly from income return, not price return.

Price return and total return for U.S. aggregate bonds

A chart shows two jagged lines traversing the x-axis, which marks the years 1999 through 2021. The y-axis indicates total return and price return for U.S. aggregate bonds, with a range of -50% to 200%. The bottom-most jagged line, price return, deviates comparatively little from the baseline of “0” over the years—indicating a fairly stable, modest return on the sale of bonds in most of the years shown. The uppermost, “total return” jagged line shows a significant increase in returns over the years, nearing 200% in the two decades-plus depicted. Total return is a combination of price return and income return. The chart illustrates how, for most mid- to long-term bond investors, the greatest potential performance benefit comes from income return, not price return.

Past performance is no guarantee of future results. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Notes: Monthly data are from December 31, 1999, to May 31, 2022. U.S. aggregate bonds are represented by the Bloomberg U.S. Aggregate Bond Index in USD. All bond income is assumed to be reinvested. Income return is the reinvestment of coupons and compound interest on the reinvestment.

Source: Bloomberg.

Why bond bear markets are fundamentally different from stock bear markets

For bond investors, the price return component’s effect on total return decreases as time extends. For stock investors, the price return component of total return is much more significant. "The Lost Decade" is a great example of this: From January 2000 through December 2009, the total annualized return for the S&P 500 was –0.95%, inclusive of the reinvestment of dividends. The negative price returns caused by the bear markets of 2000–2002 and 2007–2009 had an immense impact on long-term returns.

Now take the bond bear market of the 1970s, which was seen as a terrible time to have been invested in bonds as both inflation and nominal interest rates were soaring. But consider this: Long-term bond investors who reinvested their income returns, and remained patient as compounding took hold, nearly doubled their capital from 1976–1983. Over the longer term, bond total returns are driven much more by reinvestment of interest income and compounding than by price returns. "Investors need to look beyond the immediate pain of losses appearing in their quarterly bond portfolio statements to the longer-term upside of rising interest rates," Sheridan said.

Interest income and reinvestment account for the largest portion of total return in bond funds

Bond investing in the 1970s and early 1980s

The x-axis depicts the time frame of December 1975 through December 1983, a period notable for its high inflation and, eventually, a rising-rate environment. The y-axis shows value in dollars. For several years, the hypothetical $100,000 investment in the then-Barclay’s Capital U.S. Aggregate Bond Index would have incurred capital losses (if sold) as prevailing interest rates rose. However, income and interest on interest more than compensated for those capital losses over time—demonstrating the desirability of a long-term investing perspective, if compatible with a bond investor’s needs and goals.

Past performance is no guarantee of future results. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Notes: For this example, we assume that an investor fully funded a $100,000 investment in the Barclay's Capital U.S. Aggregate Bond Index (now Bloomberg U.S. Aggregate Bond Index) on January 1, 1976. We do not account for any expenses or taxes. Interest-on-interest return is calculated as the remainder after subtracting both income and capital returns from the total return.

Source: Vanguard calculations based on capital, income, and total return data reported by Barclay's Capital.

Bond math holds up even during fixed income shocks

Consider short-term Treasuries: interest-rate-sensitive securities whose total returns are extremely sensitive to central bank policy changes. As interest rates on the short end of the Treasury curve have risen due to expectations of further Federal Reserve policy adjustments, so too has the weighted average yield to maturity for funds that invest in these securities. That provides a better foundation to help weather further rate shocks as starting yields are now much higher. Even if rates were to rise an additional 200 basis points (bps) from here, you would now recoup any lost principal within a year and then benefit from higher yields moving forward—ultimately increasing the long-term value of your bond portfolios (see chart).

That means the time to recoup your capital from an interest rate shock depends on your starting yield. A 200 bp rate shock from a 50 bp starting yield will take longer to break even when compared to a 200 bp rate shock from a 250 bp starting yield.

"The bottom line is that as rates move higher, bonds are more attractive, not less," Sheridan said.

The silver lining in rising rates

Hypothetical impact of changes in interest rates

Three lines depict a given state of interest rates applied to a hypothetical portfolio at a starting value of $100,000. The beginning yield is assumed to be 3%, with one line representing a 1% decrease in interest rates, another line representing no change in rates, and the final line depicting a 2% increase in interest rates. At the 10-year mark, the portfolio in the 1% interest rate decrease scenario grew to $124,289.63. With no change in interest rates, the portfolio grew to $134,391.64. The portfolio in the 2% interest rate increase scenario grew to $156,684.15.

Notes: This hypothetical example begins with a portfolio value of $100,000 and does not represent the return on any particular investment. "No change" yields are based on a starting yield of 3%. For simplicity, duration was assumed to remain at two years, but in practice, as yields change, duration also changes. Such a dramatic change in yields, as this example assumes, would likely constitute a rather significant adjustment to a portfolio's weighted average duration. For purposes of illustration, we assumed no change to yields in subsequent years. Yields are not guaranteed.

Source: Vanguard.

Notes:

  • Past performance is no guarantee of future results. All investing is subject to risk, including possible loss of principal.
  • Investments in bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.