The answer may come as a nasty surprise: 12%.
A forecasted return of 2% on bonds might be too generous. Should rates rise, bonds could suffer losses damaging the return of the portfolio.
Rising Rate means Losing Value
The average duration of several Morningstar fixed income categories is listed below. Should rates rise the average fund in these categories would be expected to lose the following amounts.
In one of Bill Gross’s newsletters from a few years ago, Gross mentions that in order to generate a level of return equal to the 7.5% return bonds have delivered over the past 40 years, yields would need to drop to negative 17%.
In other words, bonds will NOT be delivering return similar to its long-term average over the past four decades.
Unappealing Set of Options
Given these circumstances, investors and advisors are left with an unappealing set of options:
- Lowering the return expectation for the overall portfolio.
- Increase the equity portion and take on more risk.
- Simply hoping that the capital markets will do better than expected and deliver high returns.
Lowering expectations or taking on more risk may not be an option for many investors and hoping that capital markets will do better than expected is a dangerous choice.
If bonds won’t provide the return stream necessary to investors, it may be time to rethink how that 40% of the portfolio is allocated.