The recent volatility in bond markets in relation to interest rate expectations has presented another test of confidence for multi-asset investors, particularly those clients invested in lower-risk, high bond allocation portfolios. But the higher-for-longer interest rate outlook is a major reason multi-asset investors should hold their nerve amid the turbulence.
Yields on 10-year government debt in the US, euro area and UK rose (reflecting a drop in prices) following central bank policy meetings and key inflation data releases in late September, namely comments from the US Federal Reserve (Fed) and Bank of England (BoE) that suggested interest rates may not come down as soon as markets were expecting.
It all comes down to the influence of interest rate expectations—and how they change—on bond returns. Given the consensus that rates are close to or at peak levels and the market’s sensitivity to changes in the outlook for rates, now is as good a time as ever to explore the role of interest rate expectations in bond market returns.
Recent bond market volatility came in the wake of comments by Fed and BoE policymakers at their September policy meetings, which came as a surprise for markets. The market consensus at the time was that interest rates would start falling in early 2024.
Interest rate expectations are a key factor in bond prices, so understanding how bond markets tend to move in response to interest rates can help investors make sense of market turbulence and ultimately focus on the long term.
"While rates may not come down as soon as markets had anticipated, if and when they do come down, we would expect to see long-term bond prices rise."
Multi-asset Product Manager, Vanguard, Europe
An increase in interest rates pushes the price of existing bonds down, while falling rates would typically see long-term bond prices rise. This repricing of bonds is based on the return an investor would receive if they held the bond to maturity (yield-to-maturity). If rates are going up, existing bond prices tend to fall because investors can earn more on newer bonds with higher coupons, so the price of existing bonds typically drops, giving investors an incentive to buy those bonds. The opposite is true when rates are falling.
In the case of government bonds, expectations about future interest rates can have an even bigger impact on bond prices than actual movements in rates. This is because when the policy rate, set by central banks, is expected to rise or fall in the future, parts of the market will adjust their bond holdings to optimise returns, which can see prices move further based on increased demand.
For example, if investors expect interest rates to fall from current levels, there tends to be increased demand for longer-term bonds as these will yield a higher return over time than shorter-term bonds. On the other hand, if markets expect interest rates to rise, then short-term bonds become more attractive as they are less sensitive to interest rate changes.
Sensitivity to interest rate changes is referred to as duration risk, which is measured in years and considers a bond’s characteristics, such as yield, coupon rate and maturity. We explain duration risk—and its role in the unprecedented 2022 bond market sell-off—in more depth here.
While it might sound like a simple relationship that investors can exploit to their advantage, markets—including many professional investors—can get it wrong. If interest rates don’t move as expected, investors that have taken a tactical position with their bond holdings could suffer far greater losses than a bond portfolio that is diversified across the yield curve.
Even if interest rates do move as expected, the yield curve, which tracks yields across the spectrum of bond maturities, doesn’t always move in parallel, i.e., parts of the curve may move more than other parts of the curve, and so taking concentrated positions at any point along the yield curve incurs a high level of risk.
Ultimately, bond holdings have historically offered a counterbalance to the volatility in equity markets1, so it’s important that multi-asset investors think very carefully before introducing further risk to their bond exposures.
While the higher-for-longer message from US and UK policymakers in September shattered the market consensus that rate cuts would come in early 2024, multi-asset investors shouldn’t lose sight of the bigger picture - that the aggressive rate-hiking programme by major central banks in the past 18 months has markedly improved our long-term return outlook for bond investors, thanks to greater income returns going forward.
The chart below shows how our long-term global bond return forecast for euro investors improved between 31 December 2021 and 30 June 2023, owing to the rise in interest rates across major economies. The solid green and gold lines show the path implied by our median 10-year annualised return forecast for global bonds at the end of 2021 and at the midpoint of 2023, respectively. The dotted lines represent the ranges from the 10th to the 90th percentiles of the forecasted distributions.
As the data suggest, bond portfolios are expected to deliver a long-term gain following the short-term pain as a result of the rapid rate-hiking programme overseen by central banks in the US, euro area and the UK.
Long-term multi-asset portfolio return forecasts
Rising rates means higher returns in the long term
Past performance is not a reliable indicator of future results. Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.
Source: Data from Refinitiv as at 30 September 2023 and Vanguard calculations in EUR, as at 30 Septmber 2023.
Notes: The chart shows actual returns for the Bloomberg Global Aggregate Bond Index EUR Hedged along with Vanguard’s forecast for cumulative returns over the subsequent 10 years as at 31 December 2021 and 30 June 2023. The dotted lines represent the ranges from the 10th to the 90th percentiles of the forecasted distributions.
IMPORTANT: The projections and other information generated by the VCMM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modelled asset class. Simulations are as at 31 December 2021 and 30 June 2023. Results from the model may vary with each use and over time.
Importantly, global bond returns are unlikely to follow a straight path along this line. Depending on where the economy is headed, it is possible that the expected returns over this period could well be unevenly distributed during the next decade.
The key message for multi-asset investors, particularly those with a preference for lower risk, is that we are most likely at or close to peak rates across key markets and the long-term outlook has improved for bond investors. While rates may not come down as soon as markets had anticipated, if and when they do trend down, we would expect to see long-term bond prices rise.
The difficulty of trying to position portfolios tactically is why maintaining a globally diversified exposure to markets is a prudent investment strategy. Where we are in the current interest rate cycle offers further reason to ensure client portfolios include a diversified exposure to global bond markets that aligns with their long-term goals and preferences around risk.
1 Vanguard analysis based on Bloomberg data. Analysis of annual total return of global equities and global bonds between 29 December 2001 and 31 December 2022 found that global bonds delivered a positive return in five of the six years that global equity markets posted losses. Bonds: Bloomberg Global Aggregate Total Return index (hedged in GBP); Shares: FTSE All-World Total Return index (in GBP). The performance of an index is not the exact representation of any particular investment. As you cannot invest directly into an index, the performance does not include the costs of investing in the relevant index. Basis of performance NAV to NAV with gross income reinvested.
Investment risk information
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.
Funds investing in fixed interest securities carry the risk of default on repayment and erosion of the capital value of your investment and the level of income may fluctuate. Movements in interest rates are likely to affect the capital value of fixed interest securities. Corporate bonds may provide higher yields but as such may carry greater credit risk increasing the risk of default on repayment and erosion of the capital value of your investment. The level of income may fluctuate and movements in interest rates are likely to affect the capital value of bonds.
IMPORTANT: The projections or other information generated by the Vanguard Capital Markets Model® regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time. The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.
The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include US and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, US money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Cahpital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.
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