Short-term pain but long-term gain for bond investors

• 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. Both euro area bonds and global bonds (hedged to the euro) have declined by more than in any 12-month period in their histories, down 16.7% and 13.9%, respectively¹.

This steep decline in bonds over the past year has reduced 10-year annualised returns since 2012, with annualised euro area bond returns falling below 1% and global bond returns dropping to 0.2%, 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: These charts show the actual 10-year annualised return of euro area bonds and global bonds (hedged) compared with the VCMM forecast made 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 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. Indices used: euro area bonds – Bloomberg Euro-Aggregate Bond Index; global bonds (hedged) – Bloomberg Global Aggregate Index Euro Hedged.

Source: Refinitiv, as at 31 October 2022 and Vanguard calculations in EUR, 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 charts also illustrate, 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 Euro-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 EUR, 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 euro area bonds² in May 2021 until September 2032 increased by 8.8%. 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 EUR 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 bonds – Bloomberg Euro-Aggregate Index; Global ex-euro area bonds (hedged) – Bloomberg Global Aggregate ex Euro Index Euro Hedged; Euro area credit – Bloomberg Euro-Aggregate Credit Bond Index; German government bonds – Bloomberg Germany Treasury Bond Index Euro; German cash – German 3-month sovereign yield; Global credit (hedged) – Bloomberg Global Aggregate – Corporates Euro Hedged; EM sovereign bonds (hedged) – Bloomberg Emerging Markets USD Aggregate Sovereign Index Euro Hedged.

Source: Vanguard calculations in EUR, 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 euro investors, our median return expectation for euro area aggregate bonds³ is now around 2.7% per year over the next decade, compared with the annual returns of around 0% we forecast a year ago. For global bonds (excluding euro area bonds, hedged to euros)⁴, we expect returns of around 2.6% per year over the next decade, compared with our year-ago median forecast of 0% per year.

Bonds continue to have a key role

Expected returns for global ex-euro area bonds in local currency terms are higher than those of euro area bonds given the relatively higher yields in several developed markets outside the euro area – however, the differences are negligible once we account for currency impacts. Furthermore, diversification through exposure to hedged global ex-euro area bonds should help to offset some risks specific to euro area fixed income markets⁵.

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 stabilizer and a long-term diversifier against equity market risk⁶.

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

¹ Euro area bonds represented by the Bloomberg Euro-Aggregate Index; global bonds represented by the Bloomberg Global Aggregate

Euro Hedged Index. Return data from Refinitiv for the Bloomberg Euro-Aggregate Index goes back to July 1998 and data for the Bloomberg Global Aggregate Euro Hedged Index goes back to February 1999. The largest 12-month losses occurred over the periods 30 September 2021 to 30 September 2022 and 31 October 2021 to 31 October 2022, respectively.

² Euro area bonds represented by the Bloomberg Euro-Aggregate Index.

³ Euro area bonds represented by the Bloomberg Euro-Aggregate Index;

⁴ Global ex-euro area bonds (hedged) represented by the Bloomberg Global Aggregate ex Euro Index Euro Hedged

⁵ Source: Phillips et al., 2014.

⁶ 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.