• Global bonds fell sharply in 2022 as central banks try to keep a lid on inflation.
  • While rising interest rates have created near-term pain for fixed income investors, we expect that those with sufficiently long investment horizons will be better off by the end of the decade as a result.
  • We believe that bonds continue to have a key role in broadly diversified portfolios.

 

By Lukas Brandl-Cheng, investment strategy analyst, Vanguard Europe

In our Vanguard Economic and Market Outlook for 2023: Beating Back Inflation, one of the key themes we explore is how central banks have responded to generationally high inflation with a globally coordinated monetary tightening regime.

And nowhere has the pain of rising interest rates been felt more acutely than in global fixed income markets. Global bonds (hedged to the Swiss franc) declined by more than in any 12-month period in their history, down 14.1%1.

This steep decline in bonds over the past year has reduced 10-year annualised returns since 2012, with annualised UK bond returns falling below 1% and global bond returns dropping to just over 1%, as the charts below show.

Near-term pain for fixed income investors

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.
Notes: This chart shows the actual 10-year annualised return of global bonds (in CHF, hedged) compared with the VCMM forecast made based on data available 10 years earlier. For example, the March 2014 data at the beginning of the charts show the actual return for the 10-year period between 31 March 2004 to 31 March 2014 (solid line) compared with the 10-year return forecast made based on data available on 31 March 2004 (dashed line). After September 2022, the dashed line is extended to show how our forecasts made between 31 December 2012 and 30 September 2022 (ending between 31 December 2022 and 30 September 2032) are evolving. The interquartile range (darker grey shaded area) represents the area between the 25th and 75th percentile of the return distribution and the lighter grey shaded area represents the area between the 5th and 95th percentile. Global bonds represented by the Bloomberg Global Aggregate CHF Hedged Index.

Source: Refinitiv, as at 31 October 2022 and Vanguard calculations in CHF, as at 30 September 2022.
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 every quarter, between 31 March 2004 and 30 September 2022. Results from the model may vary with each use and over time.

 

But as the chart also illustrates, the bond sell-off has raised our long-term forecast for fixed income returns. Initial yield is a key driver of fixed income returns. As bond prices move inversely to bond yields, the decline in values over much of 2022 means that expected fixed income investors’ potential returns are based on a more attractive starting point.

While rising interest rates have created near-term pain for fixed income investors, we expect that bond investors with sufficiently long investment horizons will actually be better off over the next decade than if this year’s sell-off hadn’t occurred. This is shown in the following chart.

Long-term gain through higher expected total return

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.
Notes: The chart shows actual returns for the Bloomberg US Aggregate Bond Index along with Vanguard’s forecast for cumulative returns over the subsequent 10 years as at 31 December 2021 and 30 September 2022. The shaded areas represent the ranges from the 10th to the 90th percentiles of the forecasted distributions. Data as at 30 September 2022.

Source: Refinitiv and Vanguard calculations in USD, as at 30 September 2022.
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 September 2022. Results from the model may vary with each use and over time.

 

The median projection for the value of a $100 investment in US bonds in May 2021 until September 2032 increased by 9.1%. This is due to the effect of duration. When interest rates rise, bonds re-price lower immediately. However, cash flows can then be reinvested at higher rates. Given enough time, the increased income from higher coupon payments will offset the price decline and an investor’s total return should increase.

Of course, bond investors are not guaranteed higher returns. The median forecast of this analysis is informed by the trajectory of yields implied by the forward yield curve, which is based on market participants’ aggregate expectations of bond yields in the future.

While our median forecast is for investors to be better off because of—not in spite of—the recent sell-off, there is a possibility that investors may not have higher wealth at the end of the decade because of further shocks. That said, this analysis should give long-term investors reasons to be optimistic about the return prospects for the fixed income part of their portfolios.

Against a backdrop of rapidly rising interest rates, our fixed income return outlook for the next decade is significantly higher than last year’s projection, as the chart below shows.

The green shoots of higher bond returns

Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.

Notes: The forecast corresponds to the distribution of 10,000 VCMM simulations for 10-year annualised nominal returns in CHF for the asset classes highlighted here. Median volatility is the 50th percentile of an asset class’s distribution of annualised standard deviation of returns. Asset-class returns do not take into account management fees and expenses, nor do they reflect the effect of taxes. Returns do reflect the reinvestment of income and capital gains. Indices are unmanaged; therefore, direct investment is not possible. Indices used: Euro area government bonds - Bloomberg Euro-Aggregate: Treasury Index CHF Hedged; Euro area credit - Bloomberg Euro-Aggregate Credit Bond Index CHF Hedged; Euro area aggregate bonds - Bloomberg Euro-Aggregate Bond Index CHF Hedged; US government bonds – Bloomberg US Treasury Index CHF Hedged; US credit – Bloomberg US Credit Bond Index CHF Hedged; US aggregate bonds – Bloomberg US Aggregate Bond Index CHF Hedged; Global credit – Bloomberg Global Aggregate – Corporates CHF Hedged; Global aggregate bonds – Bloomberg Global Aggregate Index CHF Hedged.

Source: Vanguard calculations in CHF, as at 30 September 2022.
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 30 September 2022. Results from the model may vary with each use and over time.

 

For Swiss investors, our median return expectation for euro area, US and global aggregate bonds are now around 1.5% per year over the next decade, compared with the below 0% annual returns forecast based on last year’s data.

Bonds continue to have a key role

Expected bond returns in several developed markets in local currency terms have increased by around three percentage points relative to last year's projections. In the light of significantly lower inflation and lower interest rates in Switzerland, we expect a continued appreciation of the Swiss franc so that our return expectations in Swiss franc terms have increased less and stand at almost two percentage points higher than last year. Nonetheless, diversification through exposure to hedged global bonds should help to offset some risks specific to individual fixed income markets2.

Importantly, while recent returns for fixed income have prompted some investors to call into question the role of bonds in portfolios, we continue to believe that their inclusion is warranted as a portfolio stabiliser and a long-term diversifier against equity market risk3.

To find out more, read the full Vanguard Economic and Market Outlook for 2023: Beating Back Inflation.

 

1 Global bonds represented by the Bloomberg Global Aggregate CHF Hedged Index. Return data from Refinitiv for the Bloomberg Global Aggregate CHF Hedged Index goes back to February 1999. The largest 12-month losses occurred over the period 31 October 2021 to 31 October 2022.

2 Source: Phillips et al., 2014.

3 Despite their historic sell-off this year, including fixed income in the portfolio still improved results because bonds are a lower-volatility asset. Our research (Wu et al., 2021) finds that asset allocation matters more than correlation regime when estimating outcomes over a long-term horizon.

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.

Past performance is not a reliable indicator of future results.

Some funds invest in emerging markets which can be more volatile than more established markets. As a result the value of your investment may rise or fall.

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 and 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, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital 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.

Important information

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