Vanguard’s recently published economic and investment outlook discusses their 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, Vanguard has 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 - While the return outlook for the fixed income sector is cloudy, Vanguard strongly believes that bonds can have an important place in investors’ portfolios. After all, they could provide two crucial benefits:

• Providing stability and diversification. As Mr. Buckley said, when the stock market zigs, the bond market often zags. Given the lower historical volatility of bonds versus stocks, and their smaller historical downside risk, Vanguard believes the key benefits of fixed income investing should endure in the years ahead.
• Providing income. Despite the low-yield environment, bond fund investors can benefit from rising interest rates because maturing bonds and new assets can be reinvested into higher-yielding bonds. Rising interest rates can still have a material impact on the prices of the underlying bonds, but the ability to reinvest in bonds with higher yields helps to offset the decline in price.

Source:  The Vanguard Group

  
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