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 an asset or fund in response to changes in prevailing rates).
Although investors received higher returns while taking on greater interest rate risk in the period from 1982 through 2019, this is generally viewed as an oddity and doesn’t necessarily translate into the average return on bonds investors should always expect.
If you are considering investing in bonds, it is important to understand the risk-return relationship and view a few examples to better understand how rates, yields, and risk work together over different bond maturity periods.
The Return-Risk Relationship
The most important aspect of understanding bond market risk is to grasp that there is a different relationship between risk and yield than there is between risk and total return or average return.
Risk and yield are closely related simply because investors demand greater compensation for taking bigger chances. When a bond has high-interest rate risk (e.g., greater 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 to go hand-in-hand over all time periods—even though the bond market has been bullish (on the rise) for over 30 years. The following Vanguard funds demonstrate fluctuations between periods that may affect investor decisions.
Vanguard Five-Year Funds Before April 2013
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 the longer the maturity of your investment, the stronger the returns you would have enjoyed in this particular time period. It’s critical to keep in mind, though, that this was a larger period of falling bond yields. When yields rise, the relationship between maturity length and total return will be turned on its head.
When bond yields rise, their prices tend to fall. The opposite is also true, and these fluctuations tend to conversely follow the general market interest rate.
Vanguard Five-Year Funds April to Sep. 2013
The relationship between maturity length, yield rise, and total return is demonstrated by observing the occurrences from April 30 to September 30, 2013; long-term bond yields soared with the 10-year U.S. Treasury note (used as a benchmark) rocketing from 1.67% to 2.62%, indicating a rapid drop in prices.
Here are the returns of those same three exchange-traded funds (ETFs) during that time period (yields went down, prices went up in greater increments, depending 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%
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 (remember, bond prices go up when yields fall. The farther they fall, the higher the prices go).
Recent Bond Fund Returns
Here are the historical 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:
When considering these numbers, keep in mind that past performance numbers for funds and categories can change quickly, making them deceptive. Bond prices have plummeted in the last several years, sending yields to multiyear highs.
The most important lesson is to keep in mind that if the bull market in bonds ends and rates continue to move higher for an extended period—as the Fed has promised they will—investors won’t be able to gain the same type of benefits from owning longer-term bonds that they did in the period from 2008 to 2019. In fact, quite the opposite will be true.
Don’t assume that an investment in a long-term bond fund is necessarily 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. While bonds have tended to provide good returns for the last few decades, they may not always do so.
The Balance does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.