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Predicting Bond Fund Returns: Yield or Past Performance?

A reader writes in, asking:

“My question is about bond fund returns. Which number is the best to use for determining what a customer actually gets in his account: yield or average annual returns? On the Vanguard web site the short term bond index fund has a yield of 0.42% and a 10-year average annual return of 3.77%. Which number should I be looking at?”

If you want to know how a bond fund did over a given period, look at annual return figures. If you want an estimate as to how a fund will do going forward, use the fund’s yield.

Components of Bond Returns

A bond fund’s return can come from two places:

  1. Interest on the bonds it holds, and
  2. Price appreciation for the bonds it holds if interest rates fall (note that this works in the other direction when rates rise instead of fall).

Right now, most bond funds have very good recent past performance figures. That’s because interest rates have been falling for the last few years, pushing bond prices up. But with rates as low as they are right now, they can’t fall very much further.*

In other words, when a bond fund’s yield is very low, that tells us that, for the near-term future, both of the return components are likely to be very low as well — the fund is likely to be earning a low rate of interest, and the fund can’t earn much via price appreciation, because there’s so little yield to give up.

For example, looking at the Vanguard Short-Term Bond Index Fund mentioned above, we see that its SEC yield is currently 0.42%, and it has an average duration of 2.7 years. This tells us that, for the near-term future at least, there’s nowhere for 3.77%-type returns to come from.

  • Unless nominal interest rates fall below zero, the most price appreciation the fund could experience is 1.13% (that is, a 0.42% decline in rates, multiplied by 2.7-year average duration), and
  • The only way for the fund to earn interest in excess of its 0.42% yield would be for rates to rise — which would hamper the near-term returns for the fund because it would push the price of the fund down.

Higher Yield Means Higher Risk

It’s important to understand, however, that while bond funds with higher yields do have higher expected returns, they also have the higher risk (either interest rate risk, credit risk, or both). It’s a very direct relationship. In other words, when choosing a bond fund for your portfolio, it is not usually a good idea to just pick the one with the highest yield.

*Please understand that this is not a prediction that rates will be rising any time soon. They might, or they might not. I have no idea.

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Comments

  1. Mike,

    Shouldn’t REAL returns over inflation be more important to investors than nominal returns?

    Granted, nominal returns are much easier to quantify, but the success or failure of a retirement plan depends on real returns. Safe bond investments today pretty much assure a negative real return. This noticeably negative riskless rate of return drags down the probable return on other investments as well, and creates huge problems for many people in the accumulation phase of investing. The time-tested investing strategies that you champion here might not work for young investors today.

    I know that you try hard to keep this a politics free zone, but can we really be Oblivious to the investing consequences when government runs 8% of GDP or higher deficits year after year? I believe a good case could be made that such deficit spending at best turns into a stealth tax on savings and investments of all sorts. Japan has more or less hit the wall where their stock market stops growing with public debt close to 200% of GDP. The US federal public debt is only at 105.6% of gdp today according to usdebtclock.org, but very few nations are charging as large a current deficit in % of gdp, instead having adopted some form of austerity to slow the growth of sovereign debt. The US public seems more afraid of the Fiscal Cliff (a start on austerity) than continuing to party on the stimulus of deficit spending.

    Last July, the head of Vanguard’s fixed income group guessed that the US might have until 2016 to right our fiscal ship before US Treasuries would face a bond-holder revolt that drives up interest rates. That would not be pretty: interest on the national debt quickly becomes unsustainable, and many Bogleheads would be advocating owning gold and silver and farmland!

  2. Hi Dale.

    Yes, real returns are of course more relevant than nominal returns.

    You wrote, “Safe bond investments today pretty much assure a negative real return. This noticeably negative riskless rate of return drags down the probable return on other investments as well, and creates huge problems for many people in the accumulation phase of investing.”

    I agree. And I would add that it’s likely as much of a problem for people in the distribution phase.

    You wrote, “The time-tested investing strategies that you champion here might not work for young investors today.”

    As I mentioned above, I agree that the expectations should be low at least for bonds and potentially for stocks as well. But I’m not sure what strategies you would suggest instead.

  3. Well, Mike, today I was looking again at Harry Browne’s Permanent Portfolio — which you’ve discussed on your blog. The idea of a simple somewhat defensive portfolio not as highly correlated with US stock and bond returns seems more attractive as hopes for even approaching a balanced US budget again seem more remote.

    You’ve commented positively on 1 of the 3 books by financial columnist Scott Burns and economist Laurence J. Kotlikoff on your blog. Their latest book, The Clash of Generations, has a description that begins “The United States is bankrupt, flat broke. Thanks to accounting that would make Enron blush, America’s insolvency goes far beyond what our leaders are disclosing. The United States is a fiscal basket case, in worse shape than the notoriously bailed-out countries of Greece, Ireland, and others.”

    It seems to me that those who agree with that description would tend to view the outlook not just of our portfolios but the American experiment in constitutional democracy as highly contingent upon course corrections that we make or don’t make over the next several years. These might be dangerous times to be oblivious.

    Or maybe economist Paul Krugman is right: Uncle Sam just needs to keep printing or borrowing more money to stimulate the economy. Seems unlikely to me — and that Keynesian course of action just might ruin the hopes of a lot of your readers — but this may not be the sort of discussion you want to have on your blog.

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