I recently came across an article called “The bond market: Challenges ahead” on Vanguard’s website. The article shared some of Bill McNabb’s (Chairman and CEO of Vanguard) and Robert Auwaerter’s (head of Vanguard’s Fixed Income Group) thoughts on the bond market. There were a few things in the article that I found noteworthy and would like to share with readers.
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When responding to the question, “What’s your outlook for the broad U.S. bond market?” Bill McNabb had this to say:
“The one thing we can be fairly confident about is that the next ten years of bond returns aren’t going to be what the last ten years have been, when the broad bond market returned about 5% a year. It’s almost mathematically impossible because yields currently are so low.”
Despite yields being so low, I think whether the next ten years of bond returns are like the last ten depends on how a bond investor defines his or her returns and the construction of that investor’s portfolio. In the world of stocks, a stock may go down and never return to the level at which it was purchased. When owning a non-defined-maturity bond fund, the same thing can happen. If those investors are interested in tracking total returns, they should do so on a mark-to-market basis. Individual bond investors, however, might view “returns” in a different way.
In my portfolio, I own the individual bonds of numerous companies. I have planned my income needs in a way that I am quite confident I will never be forced to sell one of those bonds to pay the bills. Therefore, I intend to hold each bond to maturity. I may change my mind in the future, but when I first purchase an individual bond, my intention is to hold it to maturity. The mark-to-market changes are irrelevant to me. From time to time, I do take advantage of the opportunity to lock in gains on a bond and roll the original investment into a different security. But should unfavorable mark-to-market movements occur in the portfolio, it is no big deal. I simply hold on to the security and can wait for maturity to get my original investment back.
Given this, I view my returns on individual bonds as the annual yield I collect on a position plus any realized gains or losses I may decide to take in the future. Unrealized gains and losses are irrelevant when the bond (absent a default) is guaranteed to one day return to par. With that in mind, if someone owned a 20-year individual bond 10 years ago and still holds that bond today, then the returns that person realizes over the next 10 years will keep up with the last 10 years’ worth of returns.
McNabb also had this to say regarding investors putting money into bond funds even as yields have declined:
“In a sense, it’s not surprising how much money has flowed into bond funds. Investors tend to focus on recent past performance . . . So investors’ behavior is understandable, but there are significant risks to chasing past performance.”
While equity investors may be known for chasing performance, I am not convinced that the reason for bond flows being so strong despite falling yields is due to performance chasing. Instead, there may be other factors at work:
To state that investors are chasing performance in an asset class that people typically hold for income and safety doesn’t seem quite right to me. I am sure if we asked around enough, we could find a few people doing so. But all in all, I would give more credence to some combination of the many reasons I listed above for the consistent inflows into bonds.
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