Vanguard: Bond ETFs

Uncertainty around the bond market and the interest rate environment are among investors’ top concerns at the moment.

Many investors are unsettled by low current yields and are anxious to know how they might be affected if—and when—interest rates start to rise.

Here’s Vanguard’s take on the state of the fixed income market, and on the proper place of bonds in a portfolio.

The outlook for interest rates and bond returns

Vanguard’s recently published economic and investment outlook discusses our outlook for interest rates and bond returns. The Federal Reserve is likely to keep a tight lid on interest rates through at least early 2015, although better-than-expected economic results (for example, if unemployment drops below the Fed’s threshold of 6.5%) or higher-than-expected inflation (above the Fed’s 2.5% target) could lead to earlier action.

For some time now, we’ve been encouraging clients to reevaluate their expectations for fixed income returns. For well over a decade, investors have benefited from a historic bond bull market, but given current interest rates, it’s difficult to imagine similar returns in the future. In fact, the Vanguard Capital Markets Model® suggests that the “central tendency” for annualized returns of the broad taxable U.S. bond market will be only 1%–2% over the next decade.

“Bonds are an area of concern for us,” Vanguard Chief Investment Officer Tim Buckley said in a recent interview. “They’re at historically low yields, and the best predictor for future bond returns is current yield. Looking forward, we have low expectations for bond returns.

“At the same time, we’ll tell you not to abandon bonds,” Mr. Buckley said. “They serve a great diversifying purpose in the portfolio. When the equity markets zig, it’s the bond markets that can zag. The other bit about bond funds is that as rates go up, yes, you may have a principal loss, but you’ll be reinvesting at a higher rate. If you stick with the portfolio, you can be better off over the long term.”

The role of bonds in a balanced portfolio