The Returns of Short, Intermediate, and Long Term Bonds
One of the tenets of investing is that with greater risk comes greater return, but this truism is much more applicable to stocks than it is to bonds, particularly when it comes to interest rate risk (i.e., the volatility of a bond or bond fund in response to changes in prevailing rates). While taking on greater interest rate risk indeed led to higher returns for bond investors in the period from 1982 through 2013, that doesn’t necessarily translate into what investors can expect in the future.
Yield Versus Total Return, and the Role of Risk in Both
The reason risk and yield are closely related is that investors demand compensation for taking on added risk. If a particular security has high-interest rate risk or higher (i.e., higher sensitivity to the health of the bond’s issuer or changes in the economic outlook), investors will demand a higher yield. As a result, 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.
With this said, investors cannot necessarily expect risk and total return (i.e., yield +/- price appreciation) to go hand-in-hand over all time periods – even though that has been the case throughout the long, 32-year bull market in bonds.
Consider 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%
These numbers show that yes, the longer the maturity of your investment, the stronger returns you would have enjoyed in this particular time period.
It’s critical to keep in mind that this was a time of falling bond yields. When yields rise, the relationship between maturity length and total return will be turned on its head.
This is illustrated by what occurred in the next six months. From April 30 to September 30, 2013, long-term bond yields soared with the 10-year U.S. Treasury note rocketing from 1.67% to 2.62% indicating a rapid drop in prices). Here are the returns of those same three ETFs during that time period:
- Vanguard Short-Term Bond ETF: -0.41%
- Vanguard Intermediate-Term Bond ETF: -4.70%
- Vanguard Intermediate-Term Bond ETF: -10.76%
This tells us that while bond yields and maturities usually have a static relationship (the longer the maturity, the higher the yield), the relationship between maturity and total return is dependent on the direction of interest rates. Specifically, shorter-term bonds will provide better total returns than longer-term bonds when yields are rising, while longer-term bonds will provide better total returns than their shorter-term counterparts when yields are falling.
With all of this said, here are the historical numbers for the various maturity categories, as expressed in the Morningstar mutual fund category return numbers as of September 30, 2014:
When considering these numbers, keep in mind that past performance numbers for funds and categories can change quickly, making them deceptive.
What This Means for You
The most important lesson here is that it's necessary to keep in mind that if the bull market in bonds ends and rates begin to move higher for an extended period, investors won’t be able to gain the same type of outperformance from owning longer-term bonds that they did in the period from 2008 to 2012. In fact, quite the opposite will be true.
The bottom line: don’t assume that an investment in a long-term bond fund is necessarily the ticket to long-term outperformance just because it has a higher yield.
Disclaimer: The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. Always consult an investment advisor and tax professional before you invest.