One of the tenets of investing is that with greater risk comes greater return, but that 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, which was unusual. The average return on bonds is not always what you would 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 get a better 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 there is high interest rate risk or 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, 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. Keep in mind that that 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 September 2013
The relationships among maturity length, yield rise, and total return can be seen in the events from April 30 through September 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 through 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 quickly, making them tricky. Bond prices have plunged in the last years, sending yields to multi-year 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 it 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 might not always do so.
Frequently Asked Questions (FAQs)
What is the annual rate of return called when you buy the bond on the open market?
Bond traders who operate in the open, secondary market need to understand the difference between a bond's coupon rate and its yield rate. The yield rate is often what traders care the most about, because that's the actual rate of return they will get for the price they pay for that bond. It might not be the rate of return for the original bondholder—that's the coupon rate. When the price of the bond changes due to market forces, the yield rate will also change. The coupon rate doesn't change, because it's always the price of the payment, compared to the original price of the bond.
How do you calculate a bond's rate of return?
To calculate the bond's rate of return, you just need to divide the annual payment by the market value of the bond. The interest payment, which may also be called the "coupon," remains steady as the price of the bond changes due to market forces. Suppose a bond were available for $1,000, paying a total of $50 over the year. In that case, would would divide 50 by 1,000, giving you a rate of return of 0.05 or 5%. If the bond price were to fall to $800, then the rate would change to 6.25% (50 ÷ 800 = 0.0625).