While sharp falls in bond markets can be hard to stomach, it’s important to remain focused on the long-term benefits of holding bonds as part of a balanced portfolio.
With interest rates on the rise and global bond markets falling significantly since the beginning of the year, there are many reasons multi-asset investors should consider before abandoning bond markets.
Bond total returns have two main components: price return and income return. Changes to interest rates cause these two main components to move in opposite directions. Rising interest rates tend to send bond yields higher, meaning prices fall. At the same time, rising yields means a greater income return going forward.
The best way to think about bond returns for long-term investors is therefore the total return, i.e., the price return plus income return.
As we show in the chart below, the long-term performance of bond investments has come mostly from income return, not price return, as coupons are reinvested at higher interest rates. So, with rates rising, investors can expect greater returns from their bond investment over the long-term.
This is particularly relevant in the current environment, because the reversal of government bond-buying programmes around the world and tighter financial conditions may lead to further volatility in bond markets. For long-term bond investors, though, rising interest rates means higher interest-paying bonds will help provide some additional buffer against price volatility in the future.
Bond bear markets: lessons from history
Bond bear markets are rare, but they can happen. Let’s take the bond crash of 1994 as an example, when global bond yields rose sharply following a policy misstep by the US Federal Reserve.
The central bank raised its target interest rate unexpectedly in February that year from 3% to 3.25% – its first interest rate hike in five years – before a series of sharp rate hikes that took the central bank’s target rate to 6% by January 1995.
UK interest rates rose more modestly from around 5% to 6% that year, but the impact on global bond returns was felt across markets with a total return of -5% for sterling investors between 1 January 1994 and 30 June 1994.
It may have been tempting for investors at the time to sell their bond holdings and cut their losses, but those who remained patient and reinvested the higher income returns benefited from the compounding effect of interest income and saw their accumulative returns almost double from 1993 to mid-2000, as the chart below shows.
The lesson, for bond investors today is to be patient and maintain a long-term perspective when looking at bond returns and the upside of rising interest rates.
Bonds tend to come through when you need them most
Understanding the dynamics of bond returns is helpful to put short-term losses into perspective. For multi-asset investors, though, it’s important to remember a key benefit of bonds in a balanced portfolio is to provide a buffer against equity market volatility, not to drive returns.
That’s because, historically, bonds have tended to move in the opposite direction to equity markets. That said, simultaneous drops in equity and bond markets can and do happen. Vanguard research found that, since the late 1980s, when equity markets declined by at least 10%, bond markets also fell about 30% of the time.
Significantly, our research also found that the longer equity markets decline, the more likely bonds are to play a stabilising role in a portfolio, as shown in the next chart, where the size of each circle is directly proportional to the number of calendar days that the period covers.
Kunal Meta, head of fixed income investment and product team in Europe at Vanguard. The views expressed above should not be taken as investment advice.