bond investing is a bear still out there

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Bond investing: Is a bear still out there?MAY 16, 2014

Brian Scott, senior investment analyst in Vanguard Investment Strategy Group, discusses

the current market for bonds and the potential implications of rising interest rates. Mr.

Scott explains why Vanguard continues to believe bonds can play an important role in the

diversification of your portfolio.

On the whole, 2013 was a down year for the bond market, but

what happened to the severe bear market that many investors were warning

about?

The common definition of a bear market is a decline of 20% or more. If you use that standard, there

has never been a bond market environment in any 12-month period of time that conforms to a loss of

20% or more. But when you look at investor behavior, it's fair to say that any period of time where

you've realized a negative return, you might call that a bear market for bonds. So we did realize a

slightly negative return in 2013. The Barclays U.S. Aggregate Bond Index declined by 2% last year.

More recently, we've seen returns that have actually been

positive. Interest rates have fallen so far in the first 3½

months or so of 2014, and we've now realized a return of about 2.4%. So

the cumulative entire period, including 2013 and the first few months of

2014, the bond market has provided, essentially, a flat return.

The key point I think we're trying to make is that trying to time changes in

interest rates or any other economic indicator is incredibly difficult.

Because the bond market enjoyed such a long run of strong returns, many bond

investors weren't accustomed to volatility. How does volatility in the bond

market differ from that in stocks?

Bonds have had a very strong long-term performance history. The Barclays U.S. Aggregate Bond Index is a widely

used benchmark to capture the returns of the U.S. bond market. And if you look at the long history of this benchmark,

which began in 1976, you realize returns of just under 8%, annualized.

Volatility in bonds, frankly, is very different from volatility in stocks. Nice rates of return, as I've expressed, over the

course of the entire history of the Barclays U.S. Aggregate Bond Index. But you realize a negative return in bonds

about 15% of the time or roughly once every six years.

With stocks, we've realized a negative return about once every four years. You're more likely to realize negative

returns in stocks, and the magnitude of those negative returns can be significantly larger. A great illustration of that is

the worst 12-month return that the stock market has ever realized was a decline of –67.6%. Bonds, on the other

hand, have had a much better downside profile, if you will. The worst 12-month return you've ever realized in bonds

is a decline of –13.9%, so nothing conforming to the traditional definition of a bear market, much less volatility, much

less frequent periods where you realize negative returns. And the point of all this is to illustrate that the primary

source of risk in your portfolio is stocks, not bonds.

Bond investing: Is a bear still out there? https://personal.vanguard.com/us/insights/article/scott-bond-investing-052014

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Rising interest rates tend to be spoken of as if they're inherently bad for bond

investors, but do they have an upside?

They do. When interest rates are rising, it means that bond prices are falling. And typically, unless you're earning a

lot of income in your portfolio, that's going to generate losses in the short term for bond investors. But the silver lining

to rising interest rates is that if you're continuing to make new purchases of bonds, in either a portfolio of bonds or a

bond mutual fund, you're going to realize higher levels of income going forward, and prospectively you could earn

higher levels of returns going forward as well. So rising interest rates for the long-term investor is likely going to

create a portfolio with more income and higher prospective returns.

Vanguard gets lots of questions from investors about their fixed income options,

and many have been asking about shortening duration1. What would you tell

them?

The gain from shortening the duration of your bond portfolio is that you reduce the downside you'd realize when

interest rates increase. Short-term bonds are less sensitive to rising interest rates than long-term bonds. So the

benefit, is you don't realize as large a loss in the short term when you have a shorter-duration bond portfolio.

The downside is that you get much less income. An example of that is, if you look at the yield to maturity of the

Barclays U.S. Aggregate Bond Index, right now it's about 2.4%. If you look at just the short-term issues within that

benchmark, those issues that have a maturity between one and three years, the yield on those is about 0.66%. So

significantly less income from those shorter-term issues.

So over the long term, if you shorten the duration of your bond portfolio, you'll likely realize much lower levels of total

return.

One final point is that while you're insulating your portfolio from rising interest rates, you're not guaranteeing

protection from loss. Short-term bonds can still realize losses in rising interest rate environments. In fact, when their

yields are much lower, the probability of them realizing losses is higher. So there's always tradeoffs involved in these

kinds of questions.

Speaking of investors who are looking for income, some may be considering

higher-yielding alternatives, or so-called bond substitutes, in their portfolios.

But what are the risks of reaching for yield?

There's no question that you can find higher-yielding alternatives than you might find in a traditional

investment-grade bond portfolio. And by investment grade, I'm referring to bonds that have a credit rating of at least

BBB or higher according to S&P, and these investment-grade bonds are considered to be highly creditworthy, very

low probability of default.

And if you move away from those issues into either issues that have below-investment-grade ratings, where the

probability of default is increasing, or even into other bond substitutes as we've come to call them, not just junk

bonds or below-investment-grade bonds but, say, dividend-paying stocks or REITs, you will, in all likelihood, realize

higher levels of income. But the trade-off is that you're also likely to realize a much higher level of price volatility. And

I've got some numbers that are, I think, frankly, very eye-opening.

When you look at the recession and the global financial crisis that began in October of 2007 and ended roughly in

March of 2009, equities, as everyone knows, did very poorly. The cumulative return during that period was a decline

of –57%. Some of these bond substitutes also delivered very poor returns. High-yield bonds declined by 26% during

this period. REITs declined by 71%, so they can perform very much like equities, especially when equities are

performing poorly.

How did investment-grade bonds do? Well, they performed very much like we would expect. They had very low

correlations to equities, especially in down-market events. The Barclays U.S. Aggregate Bond Index gained 5%


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during this period, and the Barclays U.S. Treasury Index increased 15%. So there's trade-offs involved.

What about floating-rate2 bonds? They've grown a lot both in product

availability and asset inflows, and presumably their buyers are seeking

protection against rising interest rates. What tradeoffs should they be aware of?

Sure, floating-rate bonds have become very popular because of the widespread expectation that interest rates are

going to increase. And, of course, these instruments are designed to deliver higher levels of income as interest rates

rise. So they have very low durations, very low price sensitivity to changes in interest rates.

The tradeoff is that while you're insulating your portfolio from interest rate risk, you are exposing it to more credit risk.

When you look at the credit profile of most issuers of floating-rate debt, you see that they have credit ratings that are

below investment grade.

So investors just need to recognize that the debt of these issuers, or at least most of them, is more speculative in

nature. And in terms of performance, what you historically see is, yes, they do deliver returns that are better than

investment-grade bonds during rising interest rate environments. But they also perform very much like equities when

equities are declining in value.

Vanguard's projections of bond returns over the next decade are generally below

historical averages. Do you think investors' expectations have grown too high?

No, I think investors' expectations are fairly reasonable. I cited the long-term return of the Barclays U.S. Aggregate

Bond Index of 8%. And I think most investors' advisors have come to recognize that those kinds of returns are not

likely in the short or even long term, say five or ten years. And our own expectations are significantly lower than that.

We're telling investors that we think bond returns over the next ten years are likely to be in the neighborhood of 2%

to 3%.

But we believe very strongly that there remains a strategic reason to invest in bonds. And the reason you do that is

to help balance your portfolio, keep it more diversified, and help insulate you from equity market risk, which, in our

minds, is the true source of volatility in your portfolio.

What's the most important thing investors should think about on the role that

bonds can play in their portfolio?

I think it's that element of downside protection. It's hard for investors when they hear these return expectations from

Vanguard and other sources that bonds are going to deliver low returns in the neighborhood of 2% to 3%. It's very

reasonable for investors to say, "I need more than that." Bonds traditionally have been a source of income, especially

for folks that need their portfolios to meet their spending needs currently, and those low yields make it harder to meet

income needs, for retirees in particular.

1 Duration is a measure of bond prices' sensitivity to interest rate movements.

2 Floating-rate bonds are ones whose coupon rates fluctuate with the market rate.

Notes:

CFA® is a trademark owned by CFA Institute.

All investments, including a portfolio's current and future holdings, are subject to risk.

In a diversified portfolio, gains from some investments may help offset losses from others. However, diversification

does not ensure a profit or protect against a loss.

Past performance is not a guarantee of future returns.

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


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manner, or that negative perceptions of the issuer's ability to make such payments will cause the price of that

bond to decline.

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bond investing is a bear still out there

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