The Returns of Short, Intermediate, and Long Term Bonds

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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). 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 always expect.

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.

Risk and yield are closely related simply because investors demand greater compensation for taking bigger chances. If a particular security has high-interest rate risk (i.e., 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 (i.e., yield +/- price appreciation) to go hand-in-hand over all time periods – even though that was the case throughout the aforementioned, 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, though, 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 Long-Term Bond ETF: -10.76%

And here are the five-year returns in the period from 2013 to 2018 (as of Nov. 30, 2018):

  • Vanguard Short-Term Bond ETF: .94%
  • Vanguard Intermediate-Term Bond ETF: 2.26%
  • Vanguard Long-Term Bond ETF: 4.51%

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.

Recent Bond Fund Returns

Here are the historical total returns numbers for the various bond maturity categories, as expressed by  the Morningstar bond fund category performance figures as of November 30, 2018:

Category 1-Year 3-Year 5-Year
Ultra Short-Term 1.63% 1.43% .99%
Short-Term .60% 1.39% 1.13%
Intermediate-Term -1.36% 1.53% 1.93%
Long-Term -4.04% 3.10% 4.56%

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 2018, sending yields to multiyear highs.

The Bottom Line

The most important lesson here is that it's necessary 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 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.