One of the tenets of investing is that with greater risk comes greater return. But this is much truer with stocks than it is with bonds. Stocks come with interest rate risk— the ups and downs of an asset or fund in response to changes in rates.
Investors received higher returns while taking on greater interest rate risk from 1982 through 2019, but this is viewed as odd. It doesn’t always translate into the average return on bonds that you should always expect.
It's key to understand the risk and return relationship if you're thinking of investing in bonds. Look at a few examples to better get a handle on how rates, yields, and risk work together over bond maturity periods.
The Return and Risk Relationship
Understanding bond market risk begins with grasping that there's a different relationship between risk and yield than there is between risk and average or total return.
Risk and yield are related simply because investors demand greater compensation for taking bigger chances. They'll demand a higher yield when a bond has high interest rate risk, greater sensitivity to the health of the bond’s issuer, or when there are changes in the economic outlook.
Securities issued by stable governments or large corporations tend to have below average yields, while bonds issued by smaller countries or corporations tend to have above average yields.
You can't always expect risk and total return to go hand in hand over all time periods. This is true even though the bond market has been bullish and on the rise for over 30 years.
The following Vanguard funds show the ups and downs between periods that may affect investor decisions.
Vanguard Five-Year Funds Before April 2013
These were the average annual five-year returns of three Vanguard funds through April 30, 2013, just before the bond market began to weaken.
- Vanguard Short-Term Bond ETF (BSV): 3.02%
- Vanguard Intermediate-Term Bond ETF (BIV): 6.59%
- Vanguard Long-Term Bond ETF (BLV): 9.39%
The numbers show that the longer the maturity of your investment, the stronger the returns you would have enjoyed during this time. But keep in mind that this was a larger period of falling bond yields. The relation between maturity length and total return will be turned on its head when yields rise.
Prices tend to fall when bond yields rise. The opposite is also true, and these ups and downs tend to follow the general market interest rate.
Vanguard Five-Year Funds April to Sept. 2013
The relationship between maturity length, yield rise, and total return can be seen in the events from April 30 through Sept. 30, 2013. Long-term bond yields soared along with the 10-year U.S. Treasury note, which was used as a benchmark. They rocketed from 1.67% to 2.62%, showing a quick drop in prices.
Here are the returns of those same three exchange-traded funds (ETFs) during that time. Yields went down and prices went up in greater increments based on their maturity. Note the more than 20-point swing in the long-term ETF yield.
- Vanguard Short-Term Bond ETF: -0.41%
- Vanguard Intermediate-Term Bond ETF: -4.70%
- Vanguard Long-Term Bond ETF: -10.76%
The longer the maturity of a bond fund, the more it seems to be affected.
Vanguard Five-Year Funds 2014-2019
While 10-year Treasury note yields have been falling since October 2018, the Vanguard five-year funds have increased in yield. Here are the five-year returns in the period from 2014 to 2019, as of March 4, 2020:
- Vanguard Short-Term Bond ETF: 2.00%
- Vanguard Intermediate-Term Bond ETF: 2.72%
- Vanguard Long-Term Bond ETF: 5.51%
Bond yields and maturities often have a static relationship. The longer the maturity, the higher the yield. The relation between maturity and total return depends on the direction of interest rates.
Shorter term bonds will provide better total returns than longer term bonds when yields are rising. Longer term bonds will provide better total returns than their shorter term counterparts when yields are falling. Bond prices go up when yields fall. The farther they fall, the higher the prices go.
2020 Bond Fund Returns
These were the total returns numbers for the various bond maturity categories for the Vanguard exchange-traded fund (ETF) bond fund category performance figures as of September 30, 2020:
Keep in mind that past performance numbers for funds and categories can change fast, making them tricky. Bond prices have plunged in the last years, sending yields to multiyear highs.
The Bottom Line
Investors won’t be able to gain the same benefits from owning longer term bonds as they did from 2008 to 2019 if the bull market in bonds ends and rates continue to move higher for an extended period. The Fed has promised that they will.
Don’t assume that an investment in a long-term bond fund is the ticket to performance just because it has a higher yield.
Assuming similar future performance of bonds and investments based on past performance is never a good idea. Bonds have tended to provide good returns for the last few decades, but they may not always do so.
NOTE: The Balance doesn't provide tax or investment services or advice. This information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any one investor. It might not be right for all investors. Investing involves risk, including the loss of principal.